Academic research has long noted that equities with different market capitalizations display significant differences in average returns. Further, the prices of small stocks (or large stocks), as a group, tend to move together, suggesting the presence of a common factor that can be identified by sorting stocks by market capitalization. CRSP’s capitalization-based indexes were designed to capture these differences in returns in a systematic and transparent fashion.
While clear differences in returns exist between small and large market capitalization stocks, academic research into capitalization finds no distinct statistical “breakpoints”. In fact, CRSP's research shows that an index provider's breakpoint decision is often a reflection of industry practice. Index providers have frequently made these decisions in an ad hoc fashion by using counts of securities as proxies for market capitalization (e.g., a large cap index may be defined as the largest 1000 stocks and a small cap index may include stocks ranked 1001-3000).
Count-based indexes introduce some problems:
CRSP observed that the number of listed stocks changes significantly over time, as does the percentage of market capitalization represented by a portfolio with any fixed number of stocks.
As a result, the market risk represented by a portfolio with a fixed number of stocks also varies over time.
As can be seen above, a mega cap index of the top 200 stocks jumped from around 57% of capitalization in the mid-1990's to almost 70% five years later.
Count-based benchmarks are therefore not ideal for performance evaluation or for the construction of "policy portfolios" in asset allocation.
CRSP’s solution was to base its indexes on cumulative market capitalization – a practice that parallels industry convention in international markets. CRSP set its breakpoints at levels that should look familiar to practitioners.
This choice of a cumulative capitalization method has a distinct advantage: it delivers consistent exposure to “size” without any sensitivity to a specific time or market. The resulting indexes are much more suitable for use in policy portfolios and contribute to ease of use for the asset allocator.
Portfolio Construction Made Easy:
Individual and other non-institutional investors may be particularly interested in the inherent simplicity and precision that a cumulative capitalization-based index brings to their asset allocation decisions. This is a direct result of the fact that investors care about asset weights in portfolio construction rather than counts of securities. Using a count-based index, the investor must acquire index data and determine the weights of the different capitalization segments in that index before determining the weight desired in his/her portfolio; when such an index is reconstituted, these weights must be found anew. Cumulative capitalization-based indexes, in contrast, have cap segment weights that are known, fixed values.
The following example illustrates the ease with which an investor can maintain a cap-tilted portfolio using products based on CRSP's cumulative capitalization indexes instead of traditional count-based indexes.