Plan sponsors and consultants should shift their small-cap benchmark to the Standard & Poor's 600 from the Russell 2000. As they recognize the S&P's superior methodology and appreciate the structural disadvantages of Russell's small-cap index, the S&P 600 should be the dominant small-cap benchmark in five to 10 years
The Russell 2000 now commands a huge market share in small-cap benchmarking. More than $26 billion was benchmarked against the Russell 2000 as of 1998; only about $12 billion was benchmarked to the S&P 600. I attribute the Russell lead to first-mover advantages, not structural superiority. Frank Russell Co. launched the Russell 2000 in 1986; Standard & Poor's Corp. launched the S&P 600 in 1994.
Because few portfolio managers today are benchmarked against the S&P 600, few are even familiar with its construction and sector weightings.
The S&P 600 is a superior benchmark to the Russell 2000 for portfolio managers, plan sponsors and consultants to measure small-cap performance and portfolio returns. There are compelling arguments the S&P 600 possesses superior liquidity, reconstitution methodology and weightings that better reflect the small-cap market. Also, there is a compelling argument the S&P 600 will post better returns than the Russell 2000 because the S&P 600 has, as a percentage, fewer loss-making companies, and the market will continue its rotation toward profitable traditional economy companies vs. speculative ones.
The S&P 600's superiority is attributable in part to a better method of reconstitution, which does not require speculating to outwit it. The Russell 2000's annual reconstitution distorts performance meaningfully and portfolio managers who want to stay close to the index are preoccupied for months. Plus, there is evidence of liquidity traps in the Russell 2000 that are not apparent in the S&P 600, with the caveat that all small-cap indexes have liquidity constraints.
As with other S&P indexes, the S&P 600 is constructed by a fully discretionary index committee. The committee bases its decisions on six main criteria: trading analysis, liquidity, ownership, fundamental analysis, market capitalization and sector representation. S&P attempts to create an investible benchmark by choosing only stocks with sufficient liquidity and an investible size float. It focuses its fundamental analysis around profitability.
Since inception, the S&P 600 has outperformed the Russell 2000 by 49% through Aug. 31. I believe S&P 600 returns exceed Russell 2000 returns because the S&P 600 possesses, as a percentage, fewer loss-making companies.
In addition, the S&P 600 should outperform because the Russell index possesses an inherent "loser bias" not present in the S&P 600. One investor went so far as to describe the Russell as "a busted IPO index." This characterization is a bit harsh and overly dramatic.
Russell's annual mechanical constitution methodology selects a large number of former high-flying companies moving from the Russell 1000 to the 2000, companies with stock prices and fundamentals that are rapidly deteriorating. Russell relies on the market to annually select the companies for the Russell 2000. Each June, Russell ranks U.S. companies by market cap. The largest 1,000 companies constitute the Russell 1000 index, a proxy for the large-cap market. The next 2,000 companies constitute the Russell 2000.
Said differently, the Russell 2000 includes the worst-performing large caps of the previous year. Companies often find their way into the Russell 2000 twice: during their early years when they are full of promise and their stocks rise, and then on their way down as prospects fade. In 2001, there were about 108 companies that moved from the Russell 1000 large-cap index into the Russell 2000. On average, these 108 stocks were down 62% in the year ended June 29, compared with -16% for the Russell 1000 and -1% for the Russell 2000. Interestingly, about 150 stocks joined the Russell 1000 from the 2000 on June 30 and were up an average of 57% for the same period.
The S&P 600 requires less speculation than the Russell. This matters because, in my view, S&P's methodology rewards managers for spending their time discovering good investments rather than speculating to outwit index construction. The annual reconstitution of the Russell 2000 inevitably sparks keen interest among portfolio managers who believe it is structurally disadvantaged compared with the S&P 600.
The entire Russell rebalancing exercise creates distortions to stock prices and promotes time-consuming index speculation by small-cap managers. This steals time from portfolio managers, who must work to ensure that their clients are not at a competitive disadvantage vs. the index and peers who successfully speculate to outwit the rebalancing. About 30% of the Russell is new each year. Portfolio managers anecdotally indicate that when a company joins or exits the Russell index, its value increases or decreases an average of 30%, independent of market returns. For the year ended June 29, there were approximately 609 companies added to the Russell 2000; this group was up an average 61% for the year, a figure many believe is too high to be explained by fundamentals alone. Small-cap investors cannot afford to miss a 30% relative move in approximately 30% of the index.
The S&P 600 methodology is better because the two most important tasks for an index are to accurately represent sector weightings and to be an appropriate measure of manager performance. Russell weightings do not reflect, in my opinion, either the full small-cap market weighting or the true preferences of institutional managers. From conversations, portfolio managers believe the inappropriate weightings of the Russell, particularly in financials, technology and energy, distort their behavior.
The method of reconstitution for the S&P 600 is superior. I like the human screening process that provides a quantitative and qualitative approach to constructing the S&P indexes. S&P's "as needed" continual rebalancing approach allows companies to leave the index when appropriate (if they are too large, small or irrelevant to be representative of the small caps), not just once a year. Typically, two companies per month enter and exit the S&P 600, and the market impact of the changes on the index is small.
No index is a perfect proxy, and the S&P 600 possesses shortcomings. But at the end of the day, it strikes me that the Russell 2000 is disadvantaged by its methodology in relation to the S&P 600.
James H. Furey is small-cap strategist at J.P. Morgan Securities Inc., New York. His commentary is adapted from a longer analysis.
