Is One Man’s Index Another’s Benchmark?

From our perspective, one of the more interesting stories to come out of the equity markets in 2011 was the large performance spread between the two best-known small-cap indexes, the Russell 2000 and the S&P SmallCap 600. For 2011, the Russell 2000 lost 4.2% while the S&P SmallCap 600 gained 1.0%. The difference between the two indexes for the year stands at 5.2%, the largest we have seen since the 5.9% outperformance by the S&P SmallCap 600 in 2002.

The Russell 2000 and the S&P SmallCap 600 are widely accepted benchmarks for small-cap equities. Yet each is dramatically different in composition, attribution and, perhaps most importantly, construction methodology. The Russell 2000 Index is the older and broader of the two, dating back to 1979. It measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents 99% of the U.S. equity market and approximately 8% of the total market capitalization of the larger Russell 3000 Index.

Introduced in 1994, the S&P SmallCap 600 is more concentrated, consisting of 600 names that cover approximately 3% of the domestic equity market. Outside the obvious variance in composition and sector attribution, perhaps the greatest difference between the two small-cap benchmarks is their respective construction methodology. The S&P SmallCap 600 is designed to be an efficient portfolio of companies that meet specific inclusion criteria to ensure that they are investable and financially viable. Inclusion in the index is determined subjectively by the S&P Index Committee, which adds new stocks to the index based not only on size, but also on financial viability, liquidity, adequate float size and other trading requirements.

In contrast, the Russell 2000 is more objective in natureit has no committee to determine membership and stresses the need to accurately represent the market as it is. Kelly Haughton, Strategic Director for the Russell Indexes, believes, The market should decide which stocks belong in an index, especially if the index is to provide an unbiased benchmark for measuring the results of money managers’ investment decisions.

To be sure, this difference in construction methodology has had its effect on performance and composition over time, but this was especially the case in 2011. As Steven DeSanctis of Bank of America-Merrill Lynch noted in a recent report, The biggest driver behind the gap in performance of the Russell 2000 and the S&P SmallCap is the percentage of companies in the non-earnings bucket. We deem this group as our low-quality stocks, as companies that fall into this category are expected to post negative earnings over the next 12 months. The non-earners currently represent almost 12% of the Russell 2000, whereas the group weighs in at under 5% for the S&P SmallCap.

At the same time, DeSanctis points out that the S&P SmallCap 600 has better fundamentals and lower leverage than the Russell 2000. He states, The biggest difference between the two indexes is that return on equity (ROE) and return on assets (ROA) are higher for the S&P than the Russell, and the index has slightly less debt. The weighted average ROA for the S&P SmallCap 600 stands at 6.1% versus 4.9% for the Russell 2000, whereas the ROE stands at 11.8% versus 9.7%. As for debt to capital, it stands at 24.2% for the S&P and 27.6% for the Russell.

Is there an ideal index for the small-cap world? We tend to doubt it. At The Royce Funds, we view an index or benchmark as a point of reference that provides shareholders, potential investors and ourselves with a representative return for a broad-based asset class. Unlike a lot of investment managers, we do not manage against a particular index and instead think of ourselves as benchmark agnostic.

We believe a shift in market leadership to high-quality stocks is at hand, especially within small-caps, which was quite evident in the performance differential between the Russell 2000 and the S&P SmallCap 600 in 2011.

In other words, we select companies for our portfolios because we believe that they can provide a desired rate of return, not because we think they can beat the return provided by a particular index. Our Funds are built stock by stock by employing a business buyer’s approach to investing that considers quantitative and qualitative factors. We do not begin the investment process with an eye toward replicating a benchmark. Rather, we look for well-run companies with histories of high returns on assets and on invested capital that are trading at discounted prices.

Finally, we have suggested for some time that higher-quality companies would lead the market regardless of market capitalization. As we have mentioned before, high-quality stocks look attractively undervalued to us, are defensive by nature, and tend to perform better as the economy migrates from recovery to expansion. We believe a shift in market leadership to high-quality stocks is at hand, especially within small-caps, which was quite evident in the performance differential between the Russell 2000 and the S&P SmallCap 600 in 2011.

Stay tuned

Important Disclosure Information

Francis Gannon is a portfolio manager of Royce & Associates LLC. Mr. Gannon’s thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.

The S&P 600 is an index that covers roughly the small-cap range of stocks selected by Standard & Poor’s based on market size, liquidity and industry grouping, among other factors. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The Russell 3000 index is an unmanaged, capitalization-weighted index of domestic stocks.