What To Buy After You Sell The Russell 2000

There is a strong case to be made for having a position in small cap stocks at this time. Reasons include:

1. Anticipated Fed easing may lift small caps more than large caps
2. Mean reversion – small caps have underperformed large caps by historic amounts over the past five years
3. A potential slow down or reversal of the rally in tech which has disproportionally benefitted large cap indices such as the S&P 500.

Despite this, I recently wrote an article on Seeking Alpha recommending that investors sell the Russell 2000 and ETFs such as IWM, VRTIX, and VTWO that track it, due to the negative alpha (lower returns and higher risk) that it suffers from. This is largely due to seasonal factors related to Russell 2000’s annual re-balancing of stocks on the fourth Friday of June, and the elevated transaction costs that occur at that time. In the eight years from 2016 to 2023, the Russell 2000 has underperformed the S&P 500 by a total of 28.4% during the months of May, June, July, and August.

So, while there is a good case to be made for small caps, it’s time to exit the Russell 2000 and put your money elsewhere. My original article did not offer alternatives and this article seeks to correct that omission.

I: Small Cap Indices versus the S&P 500

Table 1

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¹ As of March 28, 2024, unless otherwise noted.

² Unless otherwise indicated, Standard Deviation calculated with monthly returns over a 3-year period, P/B uses the most recent Accounting Data from September 31, 2023, P/E ratio is based on forward earnings estimates and not historic earnings.

³ As of February 29, 2024

⁴ As reported by Morningstar. Note, the Index provider reports a P/B ratio of 2.10 for the same date.

⁵ Many of the companies in these indices are too small to be covered by equity analysts, so P/E Ratios are based on historic earnings, and not on forward projections. Approximately 30% of the companies in the Russell 2000 have negative earnings. In the past when these were netted against earnings from profitable companies, there was a ridiculous P/E Ratio in excess of 100. Now, Russell omits the figures from unprofitable companies to calculate its P/E Ratio. In my opinion, the ex-Neg Earnings P/E Ratio of 16.47 that it reported on February 29, 2004 is meaningless.

Over the long term, the S&P 500 has delivered higher returns with, as measured by Standard Deviation, lower risk. Much of this outperformance can be attributed to a few Tech stocks, and this is by no means certain to continue. This outperformance has accelerated in part due to the fact that approximately 30% of the companies in the Russell 2000 had negative earnings last year, and in Q4 ’23, earnings for Russell 2000 companies fell 17.6% versus an increase of 4% for S&P 500 companies. Small Cap bulls expect mean reversion, and that eventually their performance will catch up to their larger counterparts.

⁶ As of December 29, 2023

II: Comparing the Small Cap Indices to each other

When comparing the three small cap indices, each has a similar Standard Deviation. For most of the past ten years, the best performing index has been the S&P 600, while over the past 12 months, and Year to Date, the CRSP has delivered substantially higher returns than the other two indices, albeit, still marginally trailing the S&P 500. Except for the past 12 months and Year to Date, the Russell 2000 has been the worst performer of the three.

Aside from the frequency that they rebalance, there are several other material differences between the three indices that affect performance.

1. Breakpoints: The largest company in the Russell 2000 has a much greater market cap than the largest companies in the other two indices, $46 Billion versus $21 and $7 Billion. It, and many other companies in the Russell 2000 would comfortably fit in many of the Mid Cap indices of other index providers. However, the median sized company in the Russell 2000 is the smallest of the three indices. Despite this, because all three indices are weighted by market cap, the effect of companies at the lower end of the market cap range on the overall performance of the Russell 2000 is muted. The Stocks in the S&P 600 are, on average, approximately half of the size of those in the other two indices because it divides the market cap spectrum using dollar ranges for market cap breakpoints. It is for this reason that the largest S&P 600 stock has a market cap of only $7 Billion. The other two indices use numerical break points. FTSE Russell takes the 3,000 most valuable companies in the United States, and, subject to several other restrictions, places companies 1,001 to 3,000 into the Russell 2000. Many of these companies have a market cap that is larger than the largest company in the S&P 600. Companies with a market cap below that of the three thousandth most valuable company are not included in the Russell 2000. By contrast, those companies would be included in the CRSP because it includes every company with a market cap in the bottom 85% to 98% of the universe of investible stocks.
2. IPOs: The Russell 2000 has no restrictions on IPOs being added to it, and this occurs quarterly. In June 2023, the following companies had their shares added to the index; Acrivon Therapeutics Inc. (ACRV), Mineralys Therapeutics Inc. (MLYS), Nextracker (NXT), and Skyward Specialty Insurance Group (SKWD). IPOs added to the CRSP, however, must be seasoned for 20 days, whereas IPOs added to the S&P 600 need to have been publicly traded for a period of time ranging from 6 to 12 months. Perhaps due to this feature, the Russell 2000 has been further divided into two sub-indices. As of February 2000, the Russell 2000 Growth Index consisted of 1,063 stocks, and the Russell 2000 Growth Index consisted of 1,416 stocks. It would appear that there is some overlap between the two indices, and that the index provider believes that some shares are both growth and value shares because there are only 1,947 companies in the entire Russell 2000. The respective Fact Sheets for each index can be found here.
3. Quality Controls – In order to be eligible for inclusion into the S&P 600, a firm’s most recent quarter’s earnings and the sum of its earnings for the trailing four consecutive quarters must be positive. This means that the approximately 600 companies in the Russell 2000 that weren’t profitable in Q4 2023 are not eligible for entry into the S&P 600, and there are likely a number of other companies that were profitable in that quarter, but not over the trailing four quarters, that would also be ineligible.

III: A selection of ETFs and Funds that invest in Small Caps

IWM is probably the most well-known of small cap ETFs. It tracks the Russell 2000 and it has a virtually identical record of performance compared to the index itself. Here is the most recent report from Morningstar. I recommend that investors switch out of the as well as VTWO and VRTIX.

IJR tracks the S&P 600. As is the case with IWM, it too has a virtually identical record of performance when compared to the underlying index.

VB, or the Vanguard Small-Cap ETF is a passively managed ETF that seeks to replicate the performance of the CRSP US Small Cap Index. As such, VB has a very low expense ratio of 0.05%. Although it is passively managed, VB is not required to own every share that is in the Russell 2000 and as per this report from Morningstar, it has outperformed the CRSP by anywhere from 1.25% to 2.25% over the past 10 years, depending on the time horizon being considered.

AVUV, or the Avantis U.S. Small Cap Value ETF is a $10.6 Billion AUM fund that trades on the NYSE. It has an expense ratio of 0.25%, and it benchmarks itself to the Russell 2000 Growth Index. AVUV is actively managed, meaning that it does not have to replicate the holdings and weightings of every stock in the Russell 2000 Value Index. As such, AVUV contains fewer stocks than the index itself, approximately 750 (as of January 24, 2024) as opposed to the 1,416 stocks in the underlying index. It has a slightly higher standard deviation (22.74 versus 21.88) than the Russell 2000 Value Index, but over the four and a half years that it has been in existence, it has produced superior returns compared to that index, and to the other small cap indices mentioned above. As a result, Morningstar has assigned a 5 Star rating to it.

Table 2: Returns AVUV as of March 28, 2024

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Similar to AVUV, DFSV, or the Dimensional US Small Cap Value ETF, is also a relatively new ETF (Established February 24, 2022) that benchmarks itself to the Russell 2000 Value Index. It has a slightly higher expense ratio (0.31%) then AVUV, also trades on the NYSE, and it has an AUM of $2.9 Billion. As is the case with AVUV, DFSV is actively managed, and as at February 29, 2024, it owned the shares of 988 companies. It is too young to calculate a meaningful Standard Deviation as 36 months of data are needed for this. Year to Date, it has returned 3.68%, and over the past year, it has had a return of 20.34%. I prefer AVUV to DFSV.

IV. Conclusion

Due to structural deficiencies in the way the Russell 2000 is constructed, investors owning investments such as IWM or VTWO that track this index should exit them in front of the Russell 2000’s annual re-balancing in June. Depending upon; a) your preferences for actively managed versus passively managed investments, b) your view of the short-term future, and, c) the other investments in your portfolio, investors should consider IJR, VB or AVUV for the small cap weighting of their portfolio.

IJR is a passively managed ETF that tracks the S&P 600. This index contains companies that are on average half of the size of companies in the CRSP and the Russell 2000, so arguably, it is more of a small cap “pure play”. Unlike the other two indices, companies are required to be profitable, so they are likely to have stronger balance sheets. It is an open question which of two effects of interest rates cuts by the Fed would be greater. On the one hand, lower interest rates will help repair the Balance Sheets of the 30% of companies in the Russell 2000 that were unprofitable in Q4 of 2023. On the other hand, companies with a strong balance sheet may be better positioned to take advantage of any tailwinds in the economy brought about by such cuts.

The CRSP does not have the same seasonal underperformance issues of the Russell 2000, and it has been the best performing small cap index over the past 12 months. VB seeks to track this index passively, and indeed it has outperformed the CRSP quite substantially over the past 10 years.

Finally, although AVUV is only four and a half years old, to date it has a superior record, and Morningstar has a Five Star rating for it. It should be noted that AVUV benchmarks the Russell 2000 Value Index. As this is a subset of the wider Russell 2000 Index, it is likely that it suffers from the same seasonal issues, although I haven’t tested this assumption. That said, given that AVUV is actively managed, it may be able to avoid many of these issues, by pre-positioning its portfolio in advance of June. Given its track record, one would assume that this is the case.

As always, it is a good idea to speak with a professional Financial Advisor before making investment decisions.