The capitalization bands should be based on the relative sizes of stocks, rather than on static dollar figures that may or may not be appropriate as the market rises and falls. For instance, the initial cutoff for a large-cap index could be the 700th-largest stock, as measured by total, as opposed to float-adjusted, market capitalization. Or it might be the stock representing the 85th percentile of the stock market's capitalization. (These boundaries are just suggestions, but they are roughly appropriate.)
The band around the large-capitalization cutoff could be plus or minus 150 stocks, or plus or minus five percentage points of market capitalization. A stock previously classified as small- or mid-cap would be added to the large-cap index once it became the 549th-largest stock, or the stock representing the 79th percentile of market capitalization. Similarly, a stock would be removed from the large-cap index when it became the market's 851st largest stock, or the stock representing the 91st percentile of market capitalization.
The small-cap index should be a complement of the large-cap index, with an initial cutoff of perhaps 700 for the largest stock and, as suggested above, 2,500 for the smallest stock. (The absence of a mid-cap index separating large- and small caps may seem odd, but this construction better reflects active managers' capitalization exposure.) The cutoffs should be bounded by the 300-stock bands used in the large-cap index. While the top cutoff may seem high, it reflects the holdings of small-cap managers. In fact, the performances of the Russell 2500 and Wilshire 4500 Indexes-both of which include mid-caps and small-caps-more closely correlate to the performance of small-cap managers than does that of the strictly small-cap Russell 2000 Index. Stocks smaller than the 2,500th stock could comprise a microcap index (a segment for which no index yet exists).
The mid-cap index would overlap the large-cap and small-cap indexes, with initial break points at perhaps the 400th-largest stock at the top and the 1200th-largest stock at the bottom, with both cutoffs surrounded by 300-stock bands. Figure 1 illustrates this concept. The first column shows the total stock market. The second column shows the universe of large-cap stocks; the third, that of small-cap stocks; and the fourth, that of mid-cap stocks. The dot-dash-dot lines show the initial cutoffs for the different capitalization ranges. The dash-dash-dash lines show the bands, or hurdles, that a stock must cross in order to move from one capitalization range to another.
Some investors may be concerned that, because the mid-cap index overlaps the large- and small-cap indexes, the three together would not replicate the total stock market. But overlap is a problem that investors already face when combining two or more actively managed funds, or even when complementing an active fund with an index fund. Active managers follow no hard-coded rules about market capitalization. Two managers with different mandates will frequently consider the same stock to be in their target ranges. An investor who wants a total-market index is better off investing in one directly than trying to build one with sub-indexes.