Is Bigger Better When it Comes to US Equity Index Funds?

Backtesting to the Rescue

Before we commit to our new asset allocation, let’s dig a little deeper. As it turns out, most of the small-cap and mid-cap indices that modern index funds track (S&P 600, Russell 2000, etc.) were created in the 1980’s and 1990’s. Here are the creation dates for the relevant Standard & Poor’s US Equity Indexes.

Index	Date Created
S&P 500	3/4/1957
S&P 500 Value / Growth	5/30/1992
S&P MidCap 400	6/19/1991
S&P MidCap 400 Value / Growth	5/10/1994
S&P SmallCap 600	10/28/1994
S&P SmallCap 600 Value / Growth	9/30/1996

So if these indices didn’t exist prior to the 1990’s how do we get historical data back to 1927? As is often the case with financial analysis, we use backtesting to create “Synthetic Indexes” for older data. The process involved in this technique is laid out very well in this article over at this article at Portfoliocharts.com. Essentially, you group historical return data for US stocks by market cap, then take the expensive 50% by price-to-book ratio and call it growth; the cheap 50% by price-to-book and call it value. Now this doesn’t match exactly how all modern indices are created (there are some complexities and differences in how various firms create and maintain their namesake indexes, which is a topic for another time), but this serves as a reasonable estimation of historical values in the pre-index-proliferation US stock market.

So we’ve got reasonable historical estimates on historic returns of small and mid cap funds via backtesting. The question then becomes: what does this mean for the index funds in our portfolio? I.e. can we expect to see the same performance continue into the future by using real capitalization-based index funds as our vehicle?

Out of Academia and into the Real World

Thankfully, as of 2022, real world index funds have been around for a while. Let’s take a look at the actual returns since inception for some popular Vanguard Index Funds and see how they stack up against the expected returns from our synthetic indices.

Asset Class	Fund Symbol	Inception Date	Actual Return (CAGR) Minus Corresponding Synthetic Index Return (CAGR)
Large Cap Blend (S&P 500)	VFINX	8/31/1976	-0.37%
Large Cap Value	VIVAX	11/2/1992	-0.27%
Large Cap Growth	VIGRX	11/2/1992	-0.15%
Mid Cap Blend	VIMSX	5/21/1998	+0.10%
Mid Cap Value	VMVIX	8/24/2006	-0.20%
Mid Cap Growth	VMGIX	8/24/2006	-2.01%
Small Cap Blend	NAESX	10/03/1960*	-0.70%
Small Cap Value	VISVX	05/21/1998	-0.43%
Small Cap Growth	VISGX	05/21/1998	0.00%

Negative values here mean that the index fund underperformed the synthetic index over the same time period; positive values mean the index fund outperformed the synthetic index. For the most part, the results what we would expect — i.e. the actual return on the index fund is a little lower due to things like trading costs and management funds (low but non-zero for these funds). The mid-cap growth results are a little less consistent, although it should be noted that these have the shortest time frame (only since 2007), so we can expect a little less smoothing in the data due to time.

So, generally speaking, our backtested synthetic indices are a reasonable substitute for the performance of actual index funds prior to their creation. If this is true, we should expect to see outsized-returns for small-cap and mid-cap index funds over the long term.

The Century of Large Caps Growth

Looking at the recent data, however, we see a different story. Using the actual returns of the funds listed above and filling the gaps with the synthetic index data, we can get the actual returns for these asset classes since the year 2003. We chose 2003 as the starting point for this analysis since most US equity asset classes were near a bottom in late 2002 after the dotcom crash and following bear market.

Asset Class	Annual Return 2003-2021 (CAGR)
Large Cap Blend (S&P 500)	11.37%
Large Cap Value	10.18%
Large Cap Growth	12.90%
Mid Cap Blend	12.23%
Mid Cap Value	11.74%
Mid Cap Growth	12.39%
Small Cap Blend	12.12%
Small Cap Value	11.00%
Small Cap Growth	12.60%

So far the 2000s has been the century for growth stocks. Large Cap Growth stocks have performed the best due largely to the rise of Big Tech and the trillion dollar companies. Mid-cap growth comes in second and small-cap growth takes the bronze. The value index for each capitalization category has notably underperformed it’s growth and blend counterparts. Looking at these results, we can come up with a few potential implications for our go-forward investing strategy:

1. In the new millennium, we’ve seen a paradigm shift that means large growth companies will continue to outperform while smaller companies and value stocks will lag behind.
2. Recent history has favored larger growth companies and we will likely see a swing back towards smaller and value-type companies going forward as we revert towards historical averages.

Follow your heart on this one. I tend to be more in camp #2 but — let’s be real here — nobody actually knows.

The “So What”

We’ve seen that through the use of synthetic indexes, we can estimate the performance of US Equity Asset classes dating back to 1927. While not perfect, synthetic indexes give us a sense of relative performance in the era before passive index funds and correlate fairly well with the actual returns seen via a handful of Vanguard index funds. While this trend hasn’t held recently, in the long run, history shows that small-cap and mid-cap indices, particularly their value components, tend to outperform our large-cap benchmark (the S&P 500).

As an informed index fund investor, it is worth considering adding some small-cap and mid-cap index funds to your portfolio if you’ve got a long time horizon. While this approach almost certainly adds volatility, history shows us this has a good chance of outperforming a pure S&P 500 indexing strategy in the long run.