Why Returns of Similar Growth and Low Volatility Indexes Varied So Widely

January 19, 2024

2 minute read

by Michael Hunstad, Deputy CIO, CIO Global Equities, Northern Trust Asset Management

The divergence of performance last year among supposedly similar indexes may surprise some investors. We analyze what happened.

Investors seeking to add exposure in their portfolios to equity styles such as growth, value, dividend or low volatility can choose from an array of options across index providers. We think investors understand that different indexes dedicated to the same style often produce significantly different results, but this was especially true last year with just a handful of tech-related companies leading the U.S. stock rally. As investors adjust their portfolios for 2024, it’s important to focus on index design to better understand what may drive future performance. Let’s take a closer look.

As an example, we look what happened with the S&P 500 Growth Index and Russell 1000 Growth Index. Over 20 years, the tracking error between the indexes is 2.2%, roughly representing the annual difference in returns on average. But in 2023, the difference was multiples of the tracking error. The Russell index outperformed the S&P index by over 12.5%, the largest annual difference on record. We trace the difference to how the providers defined a growth company. S&P uses a momentum factor that left it woefully underweight to technology and overweight to energy for much of 2023 compared to the Russell index. Given that momentum now resides within growthier sectors such as technology, the two indexes look much more similar headed into 2024 than in 2023. This shows just how much index composition can change in a short time.

We found a similar pattern with indexes dedicated to low volatility equities, which seek to invest in stocks that are less volatile than the broad market. Performance of the MSCI USA Minimum Volatility Index and the S&P 500 Low Volatility Index have been about the same in the five years from 2018 to 2022. But that changed drastically in 2023, when the MSCI index outperformed the S&P index, which had a loss, by about nine percentage points. Again, this occurred because different methodologies caused some very different sector weights. The MSCI index was significantly overweight to the high performing technology sector and underweight to the more modest consumer staples sector versus the S&P index.

The difference in outcomes for portfolios targeting similar exposures in 2023 demonstrates to investors the importance of staying alert to the composition and methodology of their index investments. Regardless of whether the Magnificent 7 continue their incredible run in 2024, or whether new leadership emerges, doing the homework to more deeply understand what may influence the performance of an index may lead to more predictable outcomes.