Structural Problems with the Russell 2000

Why the Russell 2000 Index Struggles Compared to the S&P 600 Small-Cap Index

There is no doubt that structural components play a crucial role in performance outcomes in the intricate world of financial indices. Russell 2000 and S&P 600 Small-Cap indices provide a prime example of this principle. Despite being viewed as a comprehensive index of small-cap stocks, the Russell 2000 has consistently underperformed. This underperformance can largely be attributed to fundamental differences in index construction and eligibility criteria.

Earnings Screening: A Qualitative Edge

Among the S&P 600's index construction criteria is a requirement that companies have a history of positive earnings before they are included. Through this requirement, less financially stable companies are excluded, which are usually more volatile and risky. In contrast, the Russell 2000 lacks this screening, resulting in a broader mix of companies, including those with weaker financial health.

This structural difference has historically resulted in the S&P 600 outperforming the Russell 2000, especially during recessionary periods when small-cap companies are at greater risk of bankruptcy.

Frequency of Reconstitution: Responsiveness to Market Changes

Another structural difference is the frequency and method of index reconstitution. In the Russell 2000, there is an annual reconstitution, which can delay exclusion of companies that have grown past small-cap status or inclusion of emerging companies that meet the criteria. By contrast, the S&P 600 is updated as-needed, allowing it to respond to market changes more quickly. Due to this flexibility, the S&P 600 can maintain a composition that more closely matches current market conditions, potentially reducing volatility and improving performance.

Historical Performance and Volatility

There is empirical evidence to support the impact of these structural differences. Over multiple time horizons, the S&P 600 has outperformed the Russell 2000 in terms of returns and volatility. The consistent performance is not just a statistical anomaly, but rather a result of prudent index construction emphasizing financial health and adaptive reconstitution.

Conclusion: The Importance of Index Construction

There's more to tracking the Russell 2000 than the S&P 600 for investors than just preferences. The S&P 600's construction, characterized by its earnings screen and responsive reconstitution process, makes it more stable and could yield better returns than the Russell 2000.

An index's structure and design remain crucial elements in determining its success as a metric of investment performance. Investors seeking to maximize returns must understand these components.