Small-Caps are Hot, but Indexes Diverge By John Spence April 16, 2002

Small- and mid-cap stocks outperformed their larger peers in 2001 and so far in 2002.

Index	1 mo	3 mo	1 yr	3 yr*
S&P 100	2.83%	-0.75%	-1.02%	-2.56%
S&P 500	3.76%	0.28%	0.24%	-2.53%
S&P Midcap 400	7.15%	6.72%	18.88%	15.16%
S&P Smallcap 600	7.90%	6.97%	21.96%	16.31%
Russell 1000	4.11%	0.74%	0.88%	-1.89%
Russell Midcap	6.00%	4.25%	9.92%	8.16%
Russell 2000	8.04%	3.99%	13.98%	9.84%

Source: Morningstar data as of 3/31/2002                    *annualized returns

As more investors and financial journalists focus their attention on hot-performing small-cap stocks (usually a surefire sign that any sector has peaked), they are noticing a significant performance discrepancy between the two established small-cap barometers: the Russell 2000 and the S&P Smallcap 600. According to Goldman Sachs, the S&P Smallcap 600 has outperformed the Russell 2000 by 47% over the period January 1994 to March 2002. Yet Goldman Sachs says the correlation between the two indexes remained stable at around 0.97.

Although this phenomenon may simply be a short-term trend, one does wonder exactly what's going on here. To gain some insight, we spoke with David Blitzer, the chief strategist at Standard & Poor's who heads the committee that decides which companies enter and exit the S&P indexes.

"There's difficulties in developing a selection process in any market sector, but it becomes even more of a daunting task in a particularly volatile sector like small-caps," said Blitzer.

He pointed out that one critical difference between the two benchmarks is that the Russell 2000 rebalances once annually in June by taking the 3,000 largest domestic companies by float capitalization and subtracting the 1,000 biggest. The S&P committee makes random decisions based on market events throughout the year.

"With the Russell 2000 annual rebalancing, how a stock is performing at the end of May is extremely important," said Blitzer. "If a stock is on a run, it will make the cutoff - if it's slumping it doesn't make the cut. That resulted in some bad timing in 1999 and 2000, when a lot of tech companies joined the Russell 2000, and that's penalized the index since then."

According to Blitzer, another reason for the difference is that the S&P committee requires that a company have four profitable quarters before it is eligible for the small-cap index.

"We look at more than just a stock's size. We're also interested in the financial viability of a company," said Blitzer. "In 1998 when the dot-com and tech companies were trading at huge price-to-earnings (p/e) ratios, we decided we needed a straightforward litmus test for financial viability."

The committee also takes into account the consistency of a company's earnings and payment of dividends. As a result, many of the dot-com high-fliers didn't find their way into the S&P Smallcap 600.

"If you look at our indexes, we're almost always underweighted in tech relative to the market as a whole," said Blitzer. "I remember in the 1990s people said we were too stodgy and that we didn't understand the so-called New Economy. Now some people say we're geniuses. Somewhere in the middle is probably true."

The annual Russell 2000 rebalancing is also difficult for index fund managers because the event draws so many players attempting to front-run the changes and generally wreaking havoc. The S&P changes take place throughout the year and are harder to predict, says Blitzer.

"Although people do guess or predict our methodology infrequently, I think it's tough to figure out what seven people in a committee are going to do in advance," said Blitzer. "We also have freedom to change our minds at the last minute."