In February 2013, Seeking Alpha contributor Ploutos wrote a ground breaking article about how to make money with small caps. He pointed out that there are two main small cap indexes, the S&P SmallCap and the Russell 2000, and that the former consistently beats the latter. From 1994-2012, the S&P SmallCap 600 outperformed the Russell 2000 by 177bps per year. Over that time frame, a dollar invested in the S&P index would have produced a cumulative return forty-seven percent higher than that of the Russell 2000.
Why is this? In Ploutos’ words: “Part of the reason for this divergence is the difference in index mechanics between the two indices. The Russell indices are reconstituted each June with the top 1000 companies by market capitalization joining the Russell 1000, and numbers 1001-3000 joining the Russell 2000. The S&P SmallCap 600 uses less of a mechanical approach. In the S&P index, constituents must be profitable (four consecutive quarters of positive earnings), liquid (30% of shares trading annually), and have at least half of their shares publicly floated.”
He continues: “The rebalancing of the Russell indices each June leads to a market anomaly. Because the Russell index changes are rules-based and predictable, have featured large number of index changes annually (roughly one-quarter historically), and given the level of indexing to the Russell 2000 is so high, arbitrageurs are able to bid up the prices of future constituents who will have increased future sponsorship and sell/short exiting constituents before indexing participants are forced to sell these now off-index positions. In a 2005 paper by Honghui Chen of the University of Central Florida, Gregory Noronha of Arizona State University-West, and Vijay Singal of Virginia Tech entitled “Index Changes and Unexpected Losses to Investors in S&P 500 and Russell 2000 Index Funds,” the authors estimate that the performance drag related to this rebalancing is between 1.30% and 1.84% annually. Comparatively, the paper estimates 0.03% to 0.12% is lost due to index changes in the S&P 500. Given the return differential between these two small cap indices has been 177bp historically, this performance drag could account for the entire return differential.
In other words: Because it’s so easy to front-run the changes to the Russell 2000 index, it consistently underperforms the S&P SmallCap 600.
You can see this from the ETFs. The Vanguard S&P Small-Cap 600 ETF (NYSEARCA:VIOO) outperforms the Vanguard Russell 2000 ETF (NASDAQ:VTWO), and the iShares Core S&P Small-Cap ETF (NYSEARCA:IJR) outperforms the iShares Russell 2000 ETF (NYSEARCA:IWM).
Investors use this information to make money in two ways. Asset allocators who use index ETFs use the S&P SmallCap ETFs rather than the Russell 2000 ETFs. And those looking for a market-neutral way to make money consider a pair trade: Long IJR, short IWM.
The outperformance isn’t guaranteed. The Russell 2000 ETFs sometimes outperform the S&P SmallCap 600. The Russell 2000 contains smaller stocks and lower quality stocks. So when those more speculative asset classes outperform, the Russell 2000 does better than the S&P SmallCap 600. At least for a short time.
Will the S&P SmallCap 600 ETFs once again outperform the Russell 2000 ETFs in 2023? Probably. With elevated inflation and interest rates, there’s little reason to expect that the more speculative Russell 2000 stocks will beat the higher quality S&P SmallCap 600 stocks. And the Russell 2000 ETFs will once again be impaired by the inferior index mechanics which Ploutos identified.
Finally, Ploutos identified a particular time of year to make the trade, and explained why. He called that article The Small-Cap Trade In July.
Authore – Abhi bhardwaj