In February 2013, Seeking Alpha contributor Ploutos wrote a landmark article on how to make money with small caps.He has two major small cap indices, the S&P SmallCap and the Russell 2000, the former It consistently beats the latter. From 1994 to 2012, the S&P SmallCap 600 outperformed the Russell 2000 by 177bps per year. Over that time frame, $1 invested in the S&P index would have produced a cumulative return 47% higher than the Russell 2000.
why is this? In Ploutos’ words, “Part of the reason for this discrepancy is the difference in the indexing mechanism between the two indices. The Russell Index is reconstituted each June, with the top 1000 companies by market capitalization joining the Russell 1000 and Numbers 1001 to 3000 join the Russell 2000. In the S&P index, constituents are profitable (four consecutive quarters of positive earnings), liquid (30% stocks traded annually), and at least half of their shares are public. must be.”
He continues: Russell index volatility is rule-based and predictable, characterized by a large number of index volatility each year (historically about a quarter), given the very high level of indexation to the Russell 2000 , the arbitrageur can bid the price. of future constituents to increase future sponsorship and sell/short existing constituents before index participants are now forced to sell off-index positions. In his 2005 paper by Honghui Chen of the University of Central Florida, Gregory Noronha of Arizona State University West, and Vijay Singal of Virginia Tech, “Index changes and unexpected changes to investors in S&P 500 and Russell 2000 index funds.” The loss of The performance decline associated with this rebalancing is estimated to be between 1.30% and 1.84% per year. By comparison, the paper estimates that 0.03% to 0.12% is lost due to changes in the S&P 500 index. Given that the return differential between these two small-cap indices has historically been 177bp, this poor performance could explain the overall return differential. ”
In other words, it is very easy to get ahead of changes to the Russell 2000 index, thus consistently underperforming the S&P SmallCap 600.
Investors use this information to make money in two ways. Asset allocators using index ETFs use the S&P SmallCap ETF instead of the Russell 2000 ETF. And for those looking for a way to make money in a market-neutral way, consider trading pairs: long the IJR and short the IWM.
Out performance is not guaranteed. The Russell 2000 ETF may outperform the S&P SmallCap 600. Therefore, the Russell 2000 outperforms the S&P SmallCap 600 when these more speculative asset classes outperform. At least for the short term.
Will the S&P SmallCap 600 ETF outperform the Russell 2000 ETF again in 2023? Probably. With inflation and rising interest rates, there is little reason to expect the more speculative Russell 2000 shares to beat the higher quality S&P SmallCap 600 shares. Also, the Russell 2000 ETF is again compromised by the poor indexing mechanism identified by Ploutos.