Beyond capping: A closer look at growth index construction

This article was written by Sean Murphy, Equity Indices Product Manager at Bloomberg.

Concentration in U.S. Equity markets has been a popular topic for quite some time, both in terms of specific names but also sectors. It has been well documented that returns over the past few years have been largely driven by only a handful of tech-oriented names such as the “Magnificent 7” (BM7T Index). As a result, the largest names in many style indices, especially on the growth side, make up a higher and higher percentage of growth benchmarks. As a result, Russell will incorporate capping into their US Style indices based on client feedback, which will impact the closely watched Russell 1000 Growth Index. But is capping the only way to improve diversification?

While an investor questioning concentration in growth indices may first look to how an index measures stocks for growth, it is important to consider the value side of the equation as well. Bloomberg US Equity Index methodology calls for assigning stocks to a style index based on a composite score consisting of both value and growth characteristics. Stocks that are very growth oriented may be exclusively assigned to the growth index; stocks that are very cheap may be exclusively assigned to value. Stocks that have both growth and value characteristics will have their market cap represented in both style indices to varying degrees. While many index providers take a similar approach, Bloomberg believes it is important to use multiple metrics to measure each style, as there is no fundamental metric that perfectly captures a company’s profile. Russell scores stocks using only one value metric, price-to-book. Bloomberg also uses this important value metric, but it is not without its shortcomings. For example, a company’s equity book value may not properly account for the value of intangible assets. As a result, less capital-intensive industries will often have a high price-to-book. The result is that using just this one metric may artificially push such sectors even further toward the growth side when calculating the composite score.

One example that highlights the importance of using multiple metrics in a rules-based approach to style index creation is AbbVie, a research-based biopharmaceutical company.  AbbVie discovers and develops medicines and therapies that solve health issues across immunology, aesthetics, neuroscience, and eye care. Like many biopharmaceutical companies, AbbVie’s business of identifying treatments relies on extensive research and development, which often results in new discoveries. These discoveries are then protected using patents, which if commercially viable, may allow the company to recoup some of the expenses associated with the discovery. The accounting treatment of these patents, however, may not properly account for the true value of the asset on the balance sheet, which can result in a lower equity book value.

When compared to the broad US index using solely price-to-book, AbbVie appears very expensive, with a price-to-book ratio more than the market average (Figure 1). But when other metrics are considered, such as price-to-earnings, AbbVie has appeared fairly priced relative to the broad market, if not underpriced (Figure 1). In the case of AbbVie, the stock was exclusively assigned to the Russell Growth Index at the end of 2023, while Bloomberg split the allocation to both the value and growth style indices.

There are additional differences between the Bloomberg and Russell approach. Russell will assign up to 35% of the starting universe (Russell 1000) market weight exclusively to the growth index (same for value, resulting in 70% of the parent universe assigned to one or the other). Bloomberg allows for a smaller percentage, with only 30% of market cap assigned exclusively to growth (combined with 30% exclusively to value side, with the remaining 40% found in both indices). If all else were equal, this means the Bloomberg Growth index will have more constituents.

When examining through year-end, the combination of using only one value metric alongside the higher all-growth allocation resulted in a meaningfully more concentrated Russell Growth index when compared to the Bloomberg equivalent, both in terms of sectors and number of constituents. In examining ETFs that track the Russell 1000 Growth Index, there were less than 400 names, with the top 10 names representing over 50% of the total value. The allocation to the Tech sector alone was 48% to end 2024 (Figure 4).

Bloomberg’s equity index methodology strikes a balance between responsiveness, representativeness, and turnover. Our indices leverage style metrics that are backed by decades of academic research and used by style investors of all types. There is no one perfect metric, so ensuring the shortcomings of one are addressed with the benefits of others is important to ensure proper representation of an investing style. By doing so, the Bloomberg 1000 Growth index avoids some of the short-term noise and concentration risk seen in other indices, while at the same time constructing an index that includes exposures investors expect to see.