Stacked Blocks

Is Your Small-Cap Exposure Right for You?

01/31/2018

Small-caps rallied in the first half of January and may be setting up for a strong year, but which small-cap U.S. benchmark should you use—the S&P SmallCap 600® Index or the Russell 2000® Index? It may be surprising to some that the two domestic small-cap benchmarks are less similar than you might imagine. 

There’s more than one way to construct a small-cap index

We certainly wouldn’t expect two different index providers to construct their indices the same way, and the methodological differences between the S&P SmallCap 600 Index and the Russell 2000 Index are prime examples. We won’t go through every single difference, but of note is the fact that the S&P index determines constituents by committee, whereas the Russell index takes a rank approach. The S&P index also employs a negative earnings screen and has a narrower market-cap eligibility. Russell Investments reconstitutes and rebalances only once a year, whereas S&P Dow Jones reconstitutes as needed and rebalances on a more frequent (quarterly) basis.

Aside from the resulting number of names (600 constituents versus 2000), the distinct approaches to construction also result in two different market capitalization profiles. Namely, the S&P SmallCap 600 Index is more clustered in terms of market capitalizations; and it has fewer larger names and fewer smaller names than the Russell 2000 Index. 

In some ways, one could argue that the S&P 600 is less of a "pure" small-cap benchmark in that it drops companies with negative earnings, effectively creating a profitability bias. To some degree this decision by S&P Dow Jones has made quite a difference in terms of performance and risk. In fact, since its inception, the S&P SmallCap 600 Index has outperformed the Russell 2000 Index, and it has achieved this feat with lower volatility.  

Since its inception in 1994, the S&P SmallCap 600 Index has outperformed the Russell 2000 Index by an average of 1.85% annually (through March 2017). Calendar-year returns reveal that the S&P SmallCap 600 Index has outperformed in 16 out of the 22 years since its inception, and in many of those years by a margin greater than 5%. Although there have been periods where the Russell 2000 Index has beaten its small-cap counterpart by sizeable margins, for example in 1999 and 2003.

Chart

Source: S&P, Russell

When viewed from a risk perspective, the differences between the small-cap benchmarks are also worth highlighting. The volatility (as measured by standard deviation) of the S&P SmallCap 600 Index has been lower than the Russell 2000 Index in nearly every calendar period since 1995, by an average of 90 basis points (bps).

Bottom Line

Although both are small-cap U.S. benchmarks, the S&P 600 Index and the Russell 2000 Index are, in fact, quite distinct. While the differences in performance and risk may be obvious to some, investors may be less aware of the differences in construction and the resulting characteristics. While there is no definitive small-cap benchmark, understanding the different approaches to index construction can help you make the best choice for your portfolio.

Potential Parametric Solution:

Parametric’s Custom CoreTM  Strategies let investors take charge of their passive mandates. Since our portfolios are held as separate accounts, we have the ability to customize to the needs of the client. Investors can select from a wide range of benchmarks and then tailor their exposure to incorporate their unique objectives.



Martha Strebinger

Martha Strebinger, CFA - Investment Strategist

Ms. Strebinger is responsible for assisting in the continued evolution of Parametric’s Responsible Investing and Custom CoreTM strategies. She earned a B.S. in Human Biology, Health & Society from Cornell University. She is a CFA® charterholder.


The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. 

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