Time to check under the hood of that index fund

Here's one more reason to avoid picking a fund based on past performance

With pundits and market analysts mostly calling for value stocks to outperform growth stocks in the year ahead, the trick for financial advisers will be picking the right index for the transition.

If you’re in the camp that expects value stocks to enjoy an advantage over growth stocks in 2020, the first step is to ignore the past performance of the indexes and take a close look under the hood to learn how fund managers are defining value.

For an example of how investors and advisers can get tripped up, consider the 2019 performance of the SPDR S&P 500 Value ETF (SPYV), which gained 31.7% and outperformed its growth counterpart, the SPDR S&P 500 Growth ETF (SPYG), by 80 basis points.

That’s not a big deal until you consider that the iShares Russell 1000 Value ETF (IWD) gained 26.1% last year while its growth counterpart, the iShares Russell 1000 Growth ETF (IWF), gained 35.9%.

The difference in the performance spreads between the two popular indexes comes down to the way growth and value characteristics are defined and identified.

Todd Rosenbluth, director of mutual fund and ETF research at CFRA, said the value criteria for the S&P index include book value, earnings, and sales to price, while the Russell index uses just book to price.

While it’s completely normal for even the broadest and most generic-looking indexes to have unique construction criteria, in this case the S&P value index was benefitting in 2019 from the inclusion of Apple, a stock that gained more 100% last year.

S&P’s year-end rebalancing has since moved Apple over to the growth index, and the stock is now the largest holding, at around 9%, for both the S&P and Russell growth indexes.

“This is a really good example of why you shouldn’t rely on past performance,” Mr. Rosenbluth said. “Because stocks are not permanently part of a growth or a value ETF, investors need to focus more on what’s inside rather than relying solely on past performance.”

Matt Chancey, a wealth manager at Dempsey Lord Smith, said he has been pivoting client portfolios to favor value stocks over growth stocks. Mr. Chancey said that the situation can be further complicated by value indexes that are enhanced with specific elements, such as dividends or share buybacks.

“All indexes are not the same because everyone has their own ideas of how to implement a strategy,” he said. “You want to make sure it’s a pure value fund and you want to know how diverse or concentrated it might be.”

[More: The worse value stocks perform, the more Rob Arnott likes them]

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