Picking The Best Small-Cap Index
So far this year, the S&P SmallCap 600 Index is up 13.6%. But the Russell 2000 Index, arguably the best-known benchmark for small stocks, is up only 11.0%.
It's not the first time the S&P 600 has had the upper hand — the index has outpaced the Russell 2000 in six of the last 10 years and 14 of the past 20. Why the consistent outperformance? There are at least three reasons:
• The S&P 600 benefits from its flexible design — stocks are added or dropped and weightings are rebalanced as needed throughout the year. In contrast, the Russell 2000 changes stocks and rebalances just once a year, in June. Some investors, anticipating Russell's moves, buy and sell certain stocks ahead of the index. Studies suggest the index often adds stocks already bid up by investors and dumps shares at beaten-down prices.
• The S&P 600 focuses on higher-quality companies hand-picked by a committee. On average, stocks in the S&P 600 earn a Quadrix Quality score of 59 and Overall score of 57, versus 54 and 53, respectively, for the Russell 2000. New S&P 600 members are required to have four consecutive quarters of positive earnings. Also, S&P 600 stocks tend to be more liquid and easier to trade than many in the Russell index.
• The S&P 600 has less exposure to microcaps, which have underperformed in 2016 and in recent years. Only stocks with market capitalizations of $400 million to $1.8 billion are potential new candidates for the S&P 600. The index has a median market value of $1.0 billion, and only 34 stocks have market values below $250 million — often considered microcap. In contrast, the Russell 2000 has a median market value of $721 million and holds 333 microcaps.
Which index is better at gauging small-caps? There is no right answer. Russell argues its index is broader and unbiased, partly because it doesn't exclude unprofitable companies. Standard & Poor's contends its index is more in tune with how investors define small stocks, partly because it limits the impact of microcaps.
Whatever the case, small-caps can help diversify a portfolio. Investors looking to mimic the S&P 600 should consider iShares Core S&P Small-Cap ($124; IJR). SPDR Russell 2000 ($73; TWOK) is also worth a look. Both funds charge a modest 0.12% expense ratio, but we'd go with the iShares fund because we prefer the S&P 600.