This past weekend a good friend remarked that it must be a good time for small-cap investors given how well the asset class is doing and is expected to do in the year ahead.
I agreed. And asked if he owned small caps.
He said that he did. And that he should probably increase his allocation to the Russell 2000 Small Cap Index for future IRA contributions.
This kicked off a discussion (that our wives promptly walked away from) of how to get easy exposure to small caps, and if the Russell 2000 really is the “right” option.
If all you care about is the punchline it’s this:
I don’t like the Russell 2000 as a long-term holding for small-cap exposure. The S&P 600 is far better. And it delivers superior returns.
S&P 600 vs. Russell 2000: A Quick Look Under the Hood
The Russell 2000 is widely viewed as the benchmark index for small-cap stocks. But the lesser-followed S&P 600 SmallCap Index is arguably the superior index.
Why?
The main reason is that the S&P 600 holds higher-quality companies. It has a profitability screen. Companies must have posted four consecutive quarters of profits to be included, and generated earnings in the most recent quarter.
In contrast, the Russell 2000 lacks a fundamental screen. It is simply a collection of 2,000 of the smallest stocks among the Russell 3000 Index, which covers 98% of the U.S. equity market.
Also, the Russell 2000 is reconstituted just once every year, in June. There is a decent amount of speculation and trading around names expected to be added and deleted at this event.
There is no annual reconstitution with the S&P 600, so traders can’t game the index all at once. It is rebalanced in March, June, September and December. Additions and deletions are decided by a committee.
The Russell 2000 Is More “Expensive”
Right now, the Russell 2000 trades with a forward PE of 27.1. That’s relatively expensive.
In contrast, the S&P 600 Index trades with a forward price-to-earnings (PE) ratio of 15.8. That’s relatively inexpensive based on the index’s historical valuation, especially during expansions. And it’s a heck of a lot less expensive than the Russell 2000.
This chart from Yardeni Research shows the historical forward PE ratios for both indices since 2000. The red line is the Russell 2000, the blue line is the S&P 600.
For those that want to go a little deeper on earnings power, using the data I have available it’s easiest to compare expected EPS figures for the iShares ETFs that track the two respective indices.
This year, EPS in the iShares S&P 600 SmallCap (IJR), which has 741 million shares outstanding, should be around $6.78.
In comparison, EPS in the iShares Russell 2000 ETF (IWM), which has 316 million shares outstanding (less than half as many as the IJR), should be around $7.02.
If we were to assume the Russell 2000 ETF (IWM) had the same number of shares outstanding as the S&P 600 Small Cap (IJR), EPS for the IWM would be only around $3.00, less than half that of the IJR.
And keep in mind, that’s for 2,000 companies in the Russell, more than three times as many as the 600 companies in the S&P 600.
In other words, there are far more companies in the Russell 2000, yet it delivers far less in earnings.
The S&P 600 Performs Better
When it comes to performance, there doesn’t appear to be any comparison between the S&P 600 and the Russell 2000 over the long term.
The S&P 600 is the hands-down winner.
Let’s go back to the mid-90s. Historical data from Index Fund Advisors shows that the S&P 600 outperformed the Russell 2000 by 1.8% annually for 20 years from 1994 to 2013. The S&P 600’s average annual gain was 11.1%, versus 9.3% for the Russell 2000.
Assuming a $10,000 investment, over that 20-year period the S&P 600 generated $17,654 more in capital gains, for a total return of $81,353. That’s nothing to sneeze at.
What about more recently?
I pulled the following comparison charts and data from FactSet yesterday morning.
As you can see, over the last decade, the S&P 600 has delivered a cumulative total return of 154% and average annual return of 9.8%. In comparison, the Russell 2000’s cumulative return is just 129.5%, and average annual return is 8.7%.
That performance gap narrows if we look at just the last five years, though the S&P 600 still leads the Russell 2000.
And the S&P 600 leads over the last three years as well. This period captures the tail end of the pandemic bull market, the subsequent bear market, and the current bull market recovery.
Interestingly, over the last year and YTD 2024, the Russell 2000 has done better, by about 3.8% and 3.2%, respectively.
This may be because lower-quality stocks, which the Russell 2000 has more of, have come up further off their 2023 lows. I expect that if we check back in on this performance derby in another year or two the S&P 600 will have pulled ahead.
The Bottom Line
There are ETFs that track both of these two indices, so in my mind there is absolutely no reason to buy the Russell 2000 over the S&P 600 for long-term investors.
The S&P 600 has better quality stocks, higher earnings power and outperforms over the long term.
What else matters?
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