Index Spotlight - Small-Cap Face-Off: Russell 2000 vs. S&P 600 By John Spence November 27, 2002

Investors who opt to index the small-cap portion of their equity portfolios often hit a stumbling block when it comes time to select a benchmark. When most people talk about small-cap stocks, they usually refer to the Russell 2000 index, which was introduced in 1984. However, the S&P SmallCap 600, launched a decade later, is also a popular benchmark for small-caps. Traditional index and exchange-traded funds tied to both indexes exist, so investors have a choice when it comes to small-cap indexes.

The Russell 2000 is certainly the more recognized of the two - an estimated $27 billion passively tracks the Russell 2000, compared to $12 billion for the S&P 600. However, the S&P 600 is finding its way onto the radar screens of an increasing number of advisors and investors.

"There is an increasing interest in the S&P 600," notes Brad Pope, head of index strategy and research at Barclays Global Investors.

Before we examine the two indexes, a brief caveat. The "best" index is the one that best serves an individual investor's goals, investment philosophy, and tolerance for risk. The notion of "no free lunch" also applies to indexes. Many index characteristics are mutually exclusive and involve some sort of tradeoff. For example, small-cap indexes sacrifice investability for completeness, since the entire universe includes tiny thinly-traded stocks that are illiquid and carry higher transaction costs.

In this corner . . .

Although both indexes measure small-cap companies, they go about that task in very different ways.

The Russell 2000 can be thought of as an objective, rules-based benchmark. The Russell 2000 is simply the bottom two-thirds of the largest 3,000 U.S.-domiciled companies. The index rebalances once a year on June 30 based on market values as of May 31. As the year wears on, the index can hold less than 2,000 names because deletions due to acquisitions will not be replaced until the next annual rebalance. The Russell 2000 is float-weighted (see glossary).

The stocks in the S&P 600, on the other hand, are selected by a committee. The index is continually reviewed by the committee, and stocks are added and deleted throughout the year. The S&P 600 has a profitability screen - only companies showing four quarters of positive earnings are eligible to make the cut. The S&P 600 is market cap-weighted.

Performance

The S&P 600 has outperformed the Russell 2000 by 3.1% per year on average since 1992, according to Merrill Lynch.

Source: Morningstar, S&P 600 pre-1994 returns are simulated

Although the Russell 2000 beat the S&P 600 by a wide margin in 1999, the S&P 600 has consistently outperformed in the post-bubble environment (notice the outperformance swing from 1999 to 2000). Most experts appear to agree that this is largely due to the profitability requirements of the S&P 600.

"I would say S&P's profitability requirements are the most significant factor regarding the recent outperformance of the S&P 600, although we haven't been able to document that yet," said Pope. "With the bubble of 1998 and 1999, technology became a big component of the Russell 2000. Tech was driving the index and the S&P 600 wasn't able to keep up. Of course, when trend reversed the S&P 600 was underweighted technology, relative to the Russell 2000."

Rebalancing and index front running

The different approaches to rebalancing methodology are the source of much of the variation between the two indexes.

"The rebalancing methodologies are significant because at certain points in time they may end up looking kind of different, especially with their sector allocations," said Pope. "If there's lots of merger and acquisition activity and big market movements, S&P has the ability to be a little more flexible in that regard. Because the Russell 2000 only rebalances once a year, it can end up looking different as the year goes on. Its market cap changes and some of the names can drop out."

Some analysts claim the annual Russell 2000 rebalancing has a detrimental effect on index fund returns because of "front running." Index front running is usually cited as a major weakness of index funds that results from their transparency. Essentially, the claim is that hedge funds can profit from an index rebalance by buying added stocks before index funds do (which drives up the price) and then selling them to the slow-witted index funds. Time (and of course timing) is of the essence when front running because you're subject to other market factors aside from "index effect." In any case, Wall Street does churn out a fair amount of research dedicated to predicting index additions and deletions, most likely because research has demonstrated that stocks do experience a price pop when added to an index (the reverse happens when they're booted from the benchmark).

Index fund proponents claim that index front running has declined because passive fund providers have evolved trading strategies to combat it. Obviously, opportunities to front run index changes are most abundant and lucrative when an index has a high asset base tracking it. For large index fund managers tracking popular benchmarks, index rebalancings take on a form of high-stakes poker where everyone knows the cards they've been dealt. Index fund providers have countered by developing trading strategies that have decreased their predictability, while minimizing index tracking error.

On the surface, it appears the Russell 2000 is vulnerable to front-running because it has a dramatic "rebalancing effect" because it reshuffles only once a year (S&P indexes rebalance every quarter, with minor adjustments along the way). Although some analysts have suggested that the Russell 2000's annual rebalance methodology has encouraged front running and hurt returns, it's difficult to substantiate the criticism. "It's tough to quantify the effect of front running regarding the Russell 2000 rebalancing," said BGI's Pope.

"I think the front running issue really boils down to the fact that there's more money indexed to the Russell 2000 compared to the S&P 600," said Scott Cooley, a Morningstar senior fund analyst. "There's just not enough money indexed to the S&P 600 to make it worthwhile, and the rebalancings aren't as extreme. It does show that there are some advantages to being an index that's not as widely used. There could be a lot of opportunity to front run the large-cap Russell 1000, but there's not a lot of money indexed to it. And the Russell 1000 is just as mechanical as the Russell 2000."

Turnover and volatility

Small-cap indexes have experienced high turnover in recent years, which can damage the inherent efficiencies of indexing. However, it's difficult to give the nod to one index over the other.

"The volatility of the indexes are so similar despite the differences in rebalancing methodologies," said Pope. "There's a perception that the S&P 600 is less volatile and has lower turnover because of the way in which it rebalances. The S&P 600 has lower turnover in certain circumstances, but the volatility in the two indexes are very similar."

Liquidity

Liquidity (naturally obtained at the expense of completeness) is an attractive feature in an index because it cuts down on transaction costs.

"If you stick to the names with better liquidity, you're probably going to have better performance all things being equal," said Cooley.

"I would say the S&P 600 is more liquid, broadly speaking, for two reasons," noted Pope. "First, it doesn't have as many names. So it doesn't have the really small illiquid companies because it doesn't dig as deep. It's also a bigger index in terms of market cap."

Completeness

Some analysts contend the Russell 2000 is the better benchmark for small-cap managers because of its completeness.

"If you're supposed to be representing a certain capitalization band, then you should be representative of all the stocks in it," said Cooley. "Otherwise you're sort of actively managing, and you're not a good benchmark for active managers. Whether the performance is better or worse, you're only reflecting the performance of part of the investment universe."

BGI's Pope offers a different perspective.

"Some argue that the Russell 2000 is a better benchmark for small-cap managers because it contains more companies," said Pope. "However, small-cap managers don't own hundreds of companies. They own very small portfolios of stocks. Additionally, these managers don't just play exclusively in the small-cap space."

Beauty is in the eye of the beholder

There is no best index for measuring small cap managers because they pursue different strategies.

"Both indexes are relevant indexes for small-cap managers," said Pope. "It's not a question of one being better. It depends on the investment style of the small-cap manager."

Likewise, there's no easy solution when selecting a small-cap index fund.

"The game comes back to what investors are trying to accomplish with the index," said Pope. "If the transparency and clarity of stock selection and deletion is important, then an investor might favor the Russell 2000."

Many investors view the Russell 2000 as the better choice for those with a desire for capital appreciation, since the index contains more companies that are still in the growth phase of their businesses. On the other hand, some investors like the stable value and earnings of the S&P 600, since it screens for profitability and only accepts more established companies.

Although the S&P 600 has outperformed the Russell 2000 in recent years, it's important to note that there have been extended periods where different market environments have favored one index over the other. It's up to each investor understand index methodologies before selecting the benchmark that's right for their particular situation.

To learn more about the Russell 2000, click here. To learn more about the S&P 600, click here.