NEW YORK - The Standard & Poor's 600 and the Russell 2000 small-cap indexes, although both handily beat the S&P 500, differed widely in performance in the first quarter, highlighting significant disparities between the two benchmarks, according to a new report by analysts at Goldman Sachs Inc.
Disparities aside, the analysts believe pension funds will jump on the small-cap outperformance over large-cap stocks to tilt to domestic small-cap equities as they "reconsider their equity allocations" in the second quarter.
"(W)e believe that the coming months will be a period of heavy activity for pension funds, with rebalancings of asset mix likely," wrote Sandy Rattray, head of U.S. derivatives and trading research; Maria More, associate; and Meric Koksal, financial analyst.
"Typically, U.S. pension funds collect performance data and select new managers in txhe first quarter. The second quarter tends to be one where the greatest implementation occurs.
"As pension fund managers reconsider their equity allocations, we expect U.S. equities will be preferred to international developed markets, and that within this, the greater diversification benefit and greater return prospects of small cap will be preferred over large cap."
The analysts report a wide gap has opened between the composition of the S&P SmallCap 600 index and the Russell 2000, in part because the S&P 600 has more profitable companies, compared with the Russell 2000's company profile.
"We have shown quantitative proof that there is a profitability bias of the S&P 600 that has helped the index over time outperform the Russell 2000." Mr. Rattray said in an interview.
The analysts, in their report, validated "the claim that the Russell 2000 index suffers from the automatic inclusion of loser companies dropping out of the Russell 1000 large-cap index."
They attributed the divergence in performance of the two indexes in part to the S&P 600's having a higher exposure to more profitable companies than the Russell 2000, a disparity that has "significantly increased over time."
"The returns from the selection of more profitable companies have been remarkable - both in magnitude and stability," they wrote.
The analysts predict the annual reconstitution of the Russell 2000 small-cap and the Russell 1000 large-cap indexes in June will make the Russell 2000 more heavily weighted to technology and healthcare, underscoring some of the disparities with the S&P 600 index.
They predict that, after the June reconstitution of the Russell 2000, technology will move to a weighting of 16.05% from 13.2%, and healthcare, to 12.99% from 11.42%. But both will follow financial services, moving to 19.97% from 22.01%, and consumer discretionary, to 17.17% from 18.82%, the two categories that have and will still dominate the index.
In the S&P 600, which is changed throughout the year as determined by a committee, technology was the dominant sector at 16% as of March 29. Consumer cyclicals was second in the S&P 600 weighted at 15%, followed by financial services at 11%. and health care, 13%
In the first quarter, the S&P 600 had a total return of 7%, compared with 4% for the Russell 2000. The S&P 500 was up only 0.3% for the quarter, they report.
The performance of the S&P 600 and the Russell 2000 has diverged substantially over the longer term, they state.
The S&P 600 index outperformed the S&P 500 by 47.1 percentage points from Dec. 31, 1999, to March 29, 2002, while the Russell 2000 beat the S&P 500 by 23 percentage points over the same period.
From January 1994 when the S&P 600 started to March 29, 2002, the S&P 600 "outperformed the Russell 2000 by a staggering" 47 percentage points.
Yet, "(d)espite this (divergence in return), the correlation between the indexes remained very stable at around 0.97."
Still, after its reconstitution, the Russell 2000 "will be less correlated with both the (S&P SmallCap 600 index) and the (S&P MidCap 400 index), primarily because of its increased technology exposure," according to the analysts. And, they wrote, the reconstituted Russell 2000 will be more volatile (an increase of 1.1%)" than the current index, also because of technology.