- Constructing client portfolios by combining multiple index funds or ETFs can lead to increased risk which could potentially affect returns.
- Understanding the nuances of index construction methodologies and how well funds align with each other can help reduce this unintended risk.
- As a result, selecting high-quality, flexible building blocks for portfolios which complement each other can help to drive better outcomes for clients.
“The proportion of growth and value stocks differs substantially depending on the index provider. This inconsistency can lead to significant deviations in portfolio performance and increased volatility.”
Equity Index Senior Investment Product Manager
More and more investors and financial advisers are building portfolios that align with individual goals by combining multiple index funds or ETFs.
While this approach offers many benefits, it may harbour a hidden risk - the varying rules for constructing indices among different providers can lead to significant deviations from benchmark exposures. This can inadvertently increase portfolio volatility and affect returns, making it crucial to understand these differences before blending exposures from different index families.
Index providers don’t follow the same rules
These problems are often invisible until market volatility occurs. When turbulence hits, investors can start to see that their portfolios are riskier than the market or than they intended.
The source of this risk stems from the different criteria that index providers use to classify equities. Comparing three well-known index providers in the US—Standard and Poor’s (S&P), Russell and CRSP (Centre for Research in Security Prices1)—illustrates how index construction rules can differ. For example, S&P, Russell and CRSP categorise the style of 46% of large-cap stocks differently.
Growth or value? It depends on the provider.
Source: Vanguard using Morningstar data as at 30 April 2025.
S&P, Russell and CRSP all use price-to-book ratios to assess a company’s value factor. However, their models meaningfully diverge from there. CRSP’s model uses 10 total factors, S&P uses six and Russell uses three. In addition, CRSP identifies each security as either growth or value, but the other two providers can label a subset of companies as belonging to both styles.
The upshot is that the proportion of growth and value stocks differs substantially depending on the index provider. This inconsistency can lead to significant deviations in portfolio performance and increased volatility.
Different methods, different market cap results
Similarly, methodology differences lead to a range of results based on market capitalisation. CRSP slices its indices into large-, mid- and small-cap categories by targeting specific percentages of market capitalisation. For example, CRSP defines large-caps as the top 85% of the total market value. In contrast, S&P and Russell use static stock counts (the largest one thousand stocks, for example) to classify equities based on size. As a result, the Russell 1000 covers 94% of total market capitalisation and the S&P 500 covers 87.5%2.
These differences have ripple effects. For static stock count indices, the market capitalisation percentage can fluctuate over time. Furthermore, S&P’s method has a few distinctive traits. It uses a quality tilt, excluding companies that don’t show a profit for four consecutive quarters. It also relies on a committee at S&P that has the final say on whether a company merits inclusion, which is a more subjective criterion than those used by other providers.
As a result of these variations, market cap categories differ significantly among providers.
Note: CRSP and Russell methodologies combine mega-cap and mid-cap into one category that they both refer to as large-cap.
Source: Vanguard calculations using FactSet data as at 1 March 2025.
Investors and advisers often have good reasons for using index funds as portfolio building blocks. This approach can provide flexibility to enhance existing portfolios or create intentional tilts towards growth or value, among other strategies. However, mixing index providers can increase risk factors exposure, tracking error and volatility, potentially leading to poorer performance.
Keeping index portfolios on track
Understanding the nuances of index construction methodologies and how well funds align with each other can help reduce unintended active risk. The fund name or classification is only the start of the story. A small-cap fund following one index provider may include a surprising number of companies that a different provider considers to be large-cap.
Assessing the tradeoffs in using funds from multiple index families instead of just one can help investors maximise market rewards. Conducting this research before investing may prevent the tax headaches that can result from restructuring existing portfolios. One option is to stick with a single index provider.
Index funds and ETFs can serve as high-quality, flexible building blocks for portfolios. Carefully selecting them with attention as to whether the indices complement each other and help to achieve financial goals is essential to giving investors the best chance for investment success.
1 An affiliate of the University of Chicago.
2 Calculations are from Vanguard using data from FactSet, as at 1 March 2025. For static stock count indices like these from Russell and S&P, the market capitalisation percentage can fluctuate over time.
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