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A Tale of Two Small-Cap Benchmarks: 10 Years Later

Sep. 27 2019 — Indices play a multifaceted role in investment management. Passive investors use indexed-linked investment products to gain exposure to particular investment universes, market segments, or strategies. Active investors use indices as benchmarks to compare actively managed funds to indices representing the active portfolio. Indices can also serve as proxies for asset class returns in formulating policy portfolios.

If indices can represent passively implemented returns in a given universe, then the risk/return profiles among various indices in the same universe should be similar. In large-cap U.S. equities, the S&P 500 and Russell 1000 have had similar risk/return profiles (9.65% versus 9.73% per year, respectively, since Dec. 31, 1993). However, in the small-cap universe, the returns of the Russell 2000 and the S&P SmallCap 600 have been notably different historically. Since year-end 1993, the S&P SmallCap 600 has returned 10.44% per year, while the Russell 2000 has returned 8.78%. In addition, the S&P SmallCap 600 has also exhibited lower volatility (see Exhibit 1).

A study performed by S&P Dow Jones Indices (S&P DJI) in 2009 (Dash and Soe) showed that return differences were primarily due to the inclusion of a profitability factor embedded in the S&P SmallCap 600. A later update of the study in 2014 (Brzenk and Soe) confirmed the continuing existence of the quality premium.

This paper renews the study now that 10 years have passed since our original paper. In addition to the profitability criteria, we also extend the analysis to two additional index inclusion criteria—liquidity and public float—that are present in the S&P SmallCap 600 but absent in the Russell 2000. Our paper shows that all else equal, U.S. small-cap companies with higher profitability, higher liquidity, and higher investability tend to earn higher returns than those with lower profitability, liquidity, and investability. Observed together, these characteristics explain the potential performance advantage of the S&P SmallCap 600.


Since December 1993, the S&P SmallCap 600 has outperformed the Russell 2000 with lower volatility, resulting in a higher risk-adjusted returns. Exhibit 1 highlights the risk/return profiles of the two indices over various investment horizons.

The rolling excess returns show the S&P SmallCap 600 outperforming the Russell 2000 with various success rates over different lengths of time. For the one-year rolling excess returns, the S&P SmallCap 600 outperformed the Russell 2000 nearly 68% of the time. Over longer horizon windows, the S&P SmallCap 600 fared better than the Russell 2000 93% of the time for the three-year period and over 98% of the time when the rolling window increased to five years (see Exhibit 2).


We attribute the performance divergence of the two small-cap benchmarks to differences in the index construction. In this section, we review the index methodology and market capitalization of the two indices.

The Russell 2000 represents 2,000 small-cap U.S. companies from the Russell 3000, which is made up of the 3,000 largest U.S. companies, as measured by their market capitalization. The index is reconstituted annually at the end of June, when securities are ranked according to their total market capitalization as of the last trading day of May. No constituent additions occur other than at the June reconstitution. During the course of the year, mergers and other corporate actions often reduce the number of Russell 2000 constituents.

In contrast, the S&P SmallCap 600 implements constituent changes on an as-needed basis. To be eligible for inclusion, companies must meet market capitalization, liquidity, public float, Global Industry Classification Standard® (GICS) sector representation, and profitability measures. Constituent deletions may occur due to bankruptcy, mergers, acquisitions, significant restructuring, or substantial violations of one or more of the eligibility measures. Since S&P Dow Jones Indices does not follow a scheduled automatic approach, additions and deletions are less predictable. Exhibit 3 highlights the methodology differences between the two indices.

Exhibit 4 compares the market capitalizations of the two indices. A priori, one might expect the Russell 2000 to have a smaller average market capitalization than the S&P SmallCap 600. With 1,400 additional names, it could potentially venture into a much smaller capitalization range. This turned out not to be the case.

The two small-cap indices have had similar weighted average market capitalization figures over time, meaning there has been little overall difference in the sizes of the constituents. However, when we compare the market cap of the largest constituent, the Russell 2000 has had a noticeable upward bias, especially farther from the annual June reconstitution. During these months, the largest companies in the Russell 2000 could be significantly larger than the average constituent, at times entering into mid- or even large-cap territory. This could be an important consideration for market participants expecting pure small-cap exposure from the Russell 2000.


Russell’s annual reconstitution process in June has been studied extensively, particularly regarding the downward price pressure exerted by the reconstitution. As winners from the Russell 2000 graduate to the Russell 1000, and losers from the Russell 1000 move down to the small-cap index, fund managers must sell winners and buy losers—thereby creating a negative momentum portfolio (Furey 2001).

Jankovskis (2002) and Chen, Noronha, and Singal (2006) estimated that the predictable nature of the Russell rebalancing process biases the return of the index downward by an average of approximately 2% per year. Additionally, Chen, Noronha, and Singal (2006) found the rebalancing impact to be 1.3% per year.

Our analysis of the monthly excess returns of the S&P SmallCap 600 versus the Russell 2000 revealed a similar finding. We grouped the average excess returns from January 1994 through July 2019 by calendar month (see Exhibits 5a and 5b). The monthly excess returns for July were higher than any other month and were statistically significant (t-stat of 2.71) at a 95% confidence interval. July was also the only calendar month to have statistically significant excess returns.

Despite the statistical significance, the June rebalancing excess return premium appears to be declining. The premium measured roughly 0.84% 10 years ago and 0.68% 5 years ago. The moderation is expected, as Russell has made enhancements to its rebalancing process in order to lessen its impact. For example, eligible initial public offerings (IPOs) are now added to the Russell 2000 on a quarterly basis.

However, the July reconstitution effect alone does not provide sufficient evidence for the S&P SmallCap 600’s outperformance. As Exhibit 6 shows, the distribution of relative outperformance is spread throughout the year, which suggests that there are other drivers behind the S&P SmallCap 600’s excess return.


Because the S&P SmallCap 600 and the Russell 2000 differ considerably in their index construction, we examine the impact of three inclusion criteria—profitability (positive earnings), liquidity, and public float. To estimate the impact of each criterion independently, as well as jointly, we form hypothetical portfolios applying each inclusion rule. We use the S&P United States SmallCap and Russell 2000 for the underlying universes.4 Similar to the Russell 2000, the S&P United States SmallCap comprises approximately 2,400 constituents and measures the smallest 15% of the listed public equity market in the U.S. by market capitalization.

We divide each universe into two groups (Group 1 and Group 2) based on each inclusion criterion. For each group, we form equal-weighted and cap-weighted portfolios. Similarly, we also equal weight and market cap weight the universe. We present the results of the equal-weighted portfolios in Exhibits 7-10 and include those of the cap-weighted portfolios in Appendix A (Exhibit 22) for reference.

To avoid survivorship bias, we include inactive and active securities. To minimize look-ahead bias, we lag the fundamental data by 45 days. Our testing period ran from December 2002 to December 2018 due to the quality of IWM holding data improving after December 2002. The portfolios are rebalanced monthly. Throughout the analysis, we use the 91-day U.S. Treasury Bill average discount rate as the risk-free rate.

Impact of the Profitability (Positive Earnings) Screen on Performance

New constituents entering the S&P SmallCap 600 are required to have positive earnings according to GAAP for the most recent four consecutive quarters and the most recent single quarter. Therefore, we group the S&P United States SmallCap and Russell 2000 universes as follows.

Group 1: Consists of securities that have positive earnings in most recent four consecutive positive earnings and the most recent quarter.

Group 2: Consists of the other securities that are not part of Group 1.

Exhibit 7 summarizes the impact of the profitability screen on performance. The security counts report the average number of constituents over the testing periods. When using the S&P United States SmallCap universe, 65% of companies fell into Group 1, while 63% of companies fell into Group 1 for the Russell 2000.

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