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In February 2013, Seeking Alpha contributor Plutos wrote: Awesome article on how to make money with small caps. He pointed out that there are two major small cap indices, the S&P SmallCap and the Russell 2000. continues to beat the latter. From 1994-2012, the S&P SmallCap 600 outperformed the Russell 2000 by 177bps per year. Over that period, a dollar invested in the S&P index would have produced a cumulative return forty-seven percent higher than the Russell 2000.
Why is this? In Blutos’s words: “Part of the reason for this difference is the difference in symbolic dynamics between the two codes. The Russell indices are restructured each June with the top 1000 companies by market capitalization joining the Russell 1000, and numbers 1001-3000 joining the Russell 2000. The S&P SmallCap 600 uses a less mechanical approach. In the S&P index, constituents must be profitable (four consecutive quarters of positive earnings), liquid (30% of shares traded annually), and at least half of the shares must be publicly floated.”
He continues: “The rebalancing of the Russell indices every June leads to market volatility. Because Russell index changes are rules-based and predictable, there are a large number of index changes annually (historically roughly a quarter), and the Russell 2000 index is so high that arbitrageurs can bid up prices. Future members who increase prior to indexing future sponsorship and sell/short exit components are now forced to sell these index-indexed positions. “Index Changes and Unexpected Losses for Investors in S&P 500 and Russell 2000 Index Funds” was written in 2005 by Honghui Chen of the University of Central Florida, Gregory Noronha of Arizona State University-Western, and Vijay Singhal of Virginia Tech. It estimates performance drag related to this restructuring to be between 1.30% and 1.84% annually. By comparison, the paper estimates that index changes in the S&P 500 have resulted in a loss of 0.03% to 0.12%. As the return differential between these two small-cap indices has historically been 177bp, this performance drag can account for the entire return difference.
In other words: Because it’s so easy to pre-empt changes in the Russell 2000 index, it consistently underperforms the S&P SmallCap 600.
Investors use this information to make money in two ways. Asset allocators using index ETFs use S&P SmallCap ETFs rather than Russell 2000 ETFs. Those looking for a market-neutral way to make money consider trading a pair: long IJR, short IWM.
Best performance is not guaranteed. Russell 2000 ETFs sometimes outperform the S&P SmallCap 600. The Russell 2000 consists of small-cap and low-quality stocks. So when those highly speculative asset classes perform well, the Russell 2000 outperforms the S&P SmallCap 600. At least for a while.
Will S&P SmallCap 600 ETFs Outperform Russell 2000 ETFs Again in 2023? Probably. With higher inflation and interest rates, there is little reason to expect the more speculative Russell 2000 stocks to outperform the higher quality S&P SmallCap 600 stocks. And Russell 2000 ETFs will once again be weakened by the downward index dynamics observed by Plutos.
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