Getting at the heart of today's global equity markets with market indexes

Stephen Wood
Stephen Wood is chief markets strategist at Russell Investments

Market indexes have existed for more than 100 years, yet in a significantly smaller — and constraining — scope and scale than what we see today. Until very recently, even large institutional investors (with portfolios covering a variety of equity asset classes and capitalizations) have had little option but to rely on a very limited set of indexes to benchmark and understand markets, and far too often regardless of how closely the investment mandate aligned with the index. Such a narrow set of benchmark tools has handicapped investors' ability to appropriately use indexes to understand and manage their investments.

Indexes have proliferated in recent decades, covering additional market capitalization ranges (i.e., midcap, microcap), investment styles (i.e., defensive and dynamic) nearly every global market and all major sectors. Indexes covering additional asset classes such as commodities and fixed income have also been introduced.

These innovations have been a positive for investors. The global investor now has access to a much more extensive, accurate and higher quality set of market benchmarking tools than ever before. The indexes of today provide the potential to better measure distinctions across asset classes, markets and capitalizations to better understand global market dynamics and maintain a global multiasset portfolio.

Indexes can now cover just about every aspect of the global markets in real time. This helps investors using the indexes to spot trends as they emerge and track them as they progress. For example, using a more granular set of indexes, we can see that the recent outperformance of U.S. megacap stocks relative to all other global asset classes, regions and capitalizations is demonstrating that the “risk-on, risk-off” phenomena has manifested in recent years beyond just the traditional equity — fixed-income tradeoff we have previously observed.

The Russell Top 50 Mega Cap index has consistently outperformed all major U.S. indexes thus far in 2012, reflecting a return of 7.2% in the third quarter and 16.2% year to date through Oct. 25. The index, which measures the performance of the largest companies in the Russell 3000, includes approximately 50 of the largest securities based on a combination of their market cap and current index membership and represents approximately 40% of the total market capitalization of the Russell 3000.

Armed with tools that offer a deeper level of information across U.S. equities than would have been available historically, we can begin to assess and hopefully better manage the risk factors driving this performance.

U.S. megacaps have enjoyed a strong run, potentially driven as much by their attractive characteristics as by the cautious and nervous mindset of today's investor. Large-cap, multinational, well-capitalized household names such as Apple, IBM, Johnson & Johnson, General Electric and Procter & Gamble are in demand by today's investors seeking strong balance sheets, well-diversified business models, and strong compliance and risk management infrastructure. In addition, many of these “megacap” companies are operating at the leanest levels ever coming out of the financial crisis and offer competitive yields in an era of historically low global interest rates. Yet for “risk-off” investors, they may be attracted to the perceived safe haven, or dependability of megacaps, which offer visibility of business model, balance sheet and earnings in an increasingly opaque world.

Increasingly sophisticated tools are needed to assess, measure and manage risk. Recently, for example, investor sentiment has been shaped by a yield-starved world that has shifted to viewing U.S. megacaps as a complement to their frustration in fixed-income yields and have used these stocks as an alternative to other U.S. and global equities. But most importantly, beyond the analytical value of the indexes, the additional market perspective allows investors to more confidently take action and better manage exposure to various asset classes, markets and investment styles. Within the equity portfolio, this could take the form of moving up or down cap tiers, from value to growth, defensive to dynamic or across global markets.

For example, a “risk-on, risk-off” approach to investing no longer is as clumsy as toggling between equities and fixed income only, but given new index tools we can also see that this has been manifested by a shifting within equities over time. Understanding this subtlety increases the opportunity set for investors in actively and intelligently managing their portfolios. Many investors can now approach “risk-on, risk-off” by diversifying within equities to stay invested. This means shifting the equity portfolio between larger- and smaller-capitalization stocks, U.S. and international markets and between defensive and dynamic-oriented stocks. The result is that an investor can more accurately manage overall portfolio risk while maintaining an allocation to equities.

These tools are increasingly important for disciplined, long-term, multiasset investors. Why? Even within an asset class, no one market sentiment or “style” endures forever. Perhaps more to the point, we've learned that no single asset class, style or manager is always the best performer. Today's winners are often tomorrow's losers, and vice versa. And while megacaps have proven a relatively attractive place for investment capital in the past year, it is important to maintain a healthy blend of asset classes, markets and capitalizations. Because of this, and using the appropriate measurement and investment tools, we believe investors can better maintain a globally diversified multiasset portfolio positioning in many different environments, particularly the current challenging low-yield, high-volatility market.

The cornerstone of any well-diversified global multiasset portfolio is to own a wide selection of asset classes and investment styles that will perform differently and perhaps complement one another over time. Indexes are critical tools in accomplishing this aim. Managing a global investment portfolio today requires a strong understanding of the current market environment as well as historical trends to inform a more sophisticated and strategic approach to asset allocation. Properly constructed and accurate indexes can enhance risk identification, improve market acuity and potentially add to the probability of a successful investor experience.

Stephen Wood is chief markets strategist at Russell Investments, Seattle.