By separating out middle-ground stocks, style performance makes more sense. Ronald Surz is president of PPCA, a San Clemente, Calif.-based software firm that provides performance-evaluation and attribution analytics, and a principal of RCG Capital Partners, a Denver, Colo.-based fund-of-hedge-funds manager.

Wild things are happening to our favorite equity indexes this year. Standard & Poor's shows domestic value stocks winning the performance race; according to Russell it's just the opposite: growth is outperforming value.

Outside the U.S., the EAFE (Europe Australia Far East) index has outstripped the S&P and the Russell, but it has underperformed against the broad foreign market by a considerable margin.

This is worth thinking about because we rely on these indexes to show us who's winning and who's losing. And for the first half of 2007, our assessment of success or failure relies very much on our choice of benchmarks.

As many of you know, I recommend custom benchmarking. But I recognize that most people just don't see the need for that. Perhaps what follows will at least give you a sense of the difficulties that can crop up when you use off-the-shelf benchmarks.

Discord

Many think it doesn't matter which style index you use because they're all about the same. That's generally true, but not for the two most popular index makers, S&P and Russell, in the first half of 2007.

The S&P large-cap value index outperformed the Russell 200 value index by 210 basis points, and the Russell 200 growth index outperformed the S&P growth index by 40 basis points. Similar results are observable for the Russell 1000 indexes versus the S&P500.

I n addition to the performance-evaluation dilemma this creates for investors and consultants, investment managers will find that they have been rewarded or penalized for tracking one of these benchmarks. It's very complicated. This discord, while infrequent, is the result of differences in methodology that can be understood by looking at the way S&P and Russell treat stocks in the gray area between value and growth.

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There are degrees of value and growth. Some growth stocks are more aggressive than others; some value stocks are "deeper value" than others. And some stocks fall squarely into neither of those categories. Russell deals with these fuzzy, middle-ground stocks by allocating them pro rata into both camps. S&P ignores the problem altogether by drawing a hard line and dividing the market's value between the value and growth styles.

A better way to deal with medial stocks is to define a separate classification called "core." Surz indexes break out value-, core- and growth-stock groupings within each market cap by establishing an aggressiveness measure that combines dividend yield, price-to-earnings ratio, and price-to-book ratio.

The top 40% (by count) of stocks in aggressiveness are designated as growth, while the bottom 40% are called value, with the 20% in the middle falling into core. The result is a family of indexes that are mutually exclusive and exhaustive, making them perfect for returns-based style analysis.

In the first half of 2007, large-cap core performed substantially worse than either large-cap value or large-cap growth. The exhibit above contrasts first-quarter style results for these three approaches and provides an explanation for the discrepancies between S&P and Russell style returns: S&P has more core in its growth index; Russell has more core in its value index.

Core usually performs in between value and growth, but about a third of the time it doesn't -- as in this year to date. It's during these unusual times that the alternative to Russell and S&P provides conspicuously valuable insights.

Surz indexes have been around for 20 years, long enough to have stood the tests of time. A list of stocks classified as core is available upon request. Details of Surz index construction and behavior are available here.

Perspective

Including some non-EAFE countries and companies in your portfolio has made a big difference this year. EAFE excludes some of the best performing countries in the world, and has generally underperformed where it has country exposure because smaller companies have fared best. The following chart puts foreign market performance into perspective.

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As you can see, EAFE lags the total non-U.S. market by 700 basis points. The ADR index has fared somewhat better than EAFE, but it still lags the broad market by a substantial margin.

Investment-manager due diligence has a poor track record. We've failed to identify skill, due mostly to our inability to figure out who's winning and who's losing. We've chosen managers who are actually losers, and even when we've been lucky enough to find actual winners the subsequent evaluations of these skillful managers frequently misjudges them.

It's been ugly, tortuous and frustrating, and it has lead many to give up -- that is, to index. -FWR

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