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I’m writing this as a warning to my performance evaluation friends, in time to be of valuable use to you as you begin third quarter performance reviews. Because they miss an important aspect of the market’s composition, Russell, S&P and Morningstar index results for the year-to-date through 9/30/08 are dangerously misleading and are likely to cause bad decisions.  And the problems spill over into the new and growing area of target date funds, although there are only a few indexes from which to choose.

Hire/fire decisions are complex enough in “normal” times, and they make my hair hurt in these crazy times, so index flaws are scary problems, in keeping with the current Halloween season and the continuing market turmoil.

The following commentary describes the problems and recommends solutions, beginning with U.S. equity investments and then target date funds.

U.S. Stock Indexes

“It doesn’t matter which style indexes you use because they’re all about the same.” We’ve heard this often enough and it would seem to be the case in the first nine months of 2008, but not so. As shown in the following exhibit, the most popular indexes – Russell, S&P and Morningstar – all agree that value and growth have lost about the same, roughly 20%. This concurrence should give us confidence that -20% is the right number, but both Russell and S&P are missing an important component of the market, namely the stuff in the middle, in between value and growth, that I call Core. Morningstar does include this important Core component, but it uses different rules than Surz Indexes described below, so their results are materially different. Surz Indexes were launched in 1986. Morningstar indexes were launched in 1997.

The inclusion of Core paints a dramatically different picture where Value has outperformed Growth, and Core has outperformed both Value and Growth. Morningstar’s Core also outperforms its Value and Growth indexes, but their returns are different than Surz because their rules are different than Surz Index rules. Morningstar Core is down 15% year-to-date.

Why is this Core-Value-Growth performance ranking important? Because investment managers compared to the popular indexes will be misjudged at this very critical time of high investor anxiety. Core typically outperforms when investors lack conviction, favoring neither value nor growth. Also, Barry Mendelson, president of Capital Market Consultants, has recently written about his belief that investors should prefer the stocks in the middle during the current crisis – they are Goldilocks stocks. 

Now more than ever it’s important to get the benchmark right. Otherwise today’s faulty decisions will undermine future performance.

This type of index discord, while infrequent, is explained by differences in methodology that can be best understood by considering how stocks in the gray area, between value and growth, are treated by index providers. There are degrees of value and growth, so some growth stocks are more aggressive growth than others, and some value stocks are deeper value than others.  And some stocks have characteristics that are not clearly value or growth – they’re the stuff in the middle. Russell deals with this issue by pro-rata allocating these fuzzy stocks into both value and growth. S&P ignores the problem altogether by drawing a hard line that divides half of the market’s value between value and growth. By contrast, both Surz and Morningstar deal with this stocks-in-the-middle issue by defining a separate category called “Core”. I’ll describe the Surz classification rules so you can see how it works.

Surz indexes break out value, core, and growth stock groupings within each market cap by establishing an aggressiveness measure that combines dividend yield, price-to-earnings ratio, and price/book ratio. The top 40% (by count) of stocks in aggressiveness are designated as growth, while the bottom 40% are called value, with the 20% in the middle falling into core. The result is a family of indexes that are mutually exclusive and exhaustive, making them perfect for style analyses, both returns-based and holdings-based style analysis.

Core usually performs in between value and growth, but about a third of the time it does not, like the current year to date. It is during these unusual times that the alternative to Russell and S&P provides conspicuously valuable insights. Surz indexes have been around for more than 20 years, long enough to have stood the tests of time. A list of stocks classified as core is available upon request. Details of Surz index construction and behavior are available at
http://www.ppca-inc.com/SurzStyles/surz_styles.htm.

So, what can you do to take advantage of this insight? Obviously, you can use the index results above, but I’m giving you something even better -- the gift in the next exhibit, which provides superior peer groups for your ranking pleasure and enlightenment. Just plot your fund’s return against the appropriate group.  As you can see there is very little overlap in the intra-quartiles, so misclassifying a manager will lead to erroneous evaluations. Also, classification bias in traditional peer groups is likely to be problematic in the nine months to date. For an entertaining and informative discussion of this little known bias please visit http://www.ppca-inc.com/pdf/Blob-Peer-Group-Bias.pdf.

The universes in this exhibit are created using an unbiased scientific approach called Portfolio Opportunity Distributions (PODs). They represent all of the possible portfolios that managers could have held when selecting stocks from their respective indexes. In essence, hypothetical monkeys expand an index into a peer group by simulating all the portfolios that could have been formed from stocks in that index. By contrast, traditional peer groups are very poor barometers of success or failure because of their myriad biases. Everyone knows that it’s easy to find a peer group provider that makes you look good, but for some reason the industry tolerates, even condones, this deceptive practice. PODs are bias free and are therefore a much more reliable performance evaluation backdrop, plus POD universes were available on October 2, many weeks before the “real” biased peer groups. As John Stossel says on ABC TV News:”Give me a break.” Please visit http://www.ppca-inc.com/PODs/pods.htm for more details on this important breakthrough.

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