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) about how to get easy exposure to small caps, and whether 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 has historically delivered 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 Small Cap 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 must have 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.
The Russell 2000 is also 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, making it much harder for traders to game the index all at once. Instead, it is rebalanced in March, June, September and December, with additions and deletions determined by a committee.
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The Russell 2000 Is More “Expensive”
The quality difference between the two indices shows up not only in company fundamentals, but also in valuation.
Right now, the Russell 2000 trades with a forward P/E ratio of 25.8. That’s relatively expensive.
In contrast, the S&P 600 trades with a forward P/E ratio of 15.8. That’s relatively inexpensive based on the index’s historical valuation, especially during economic 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 2004. The red line is the Russell 2000; the blue line is the S&P 600.
For those who want to go a little deeper on earnings power, using data from FactSet, 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 Small Cap ETF (IJR) should be around $8.80.
In comparison, EPS in the iShares Russell 2000 ETF (IWM) should be around $9.40.
While the Russell 2000 ETF generates slightly higher earnings per share, investors are paying a much higher price for those earnings. Based on current prices, the earnings yield of the IJR is approximately 6.0%, compared to just 3.2% for the IWM.
In other words, each dollar invested in the S&P 600 currently buys nearly twice as much earnings power as a dollar invested in the Russell 2000. That’s one reason the S&P 600 has historically offered better risk-adjusted returns than its better-known rival.
The S&P 600 Performs Better Over the Long Run
When it comes to performance, there doesn’t appear to be much 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-1990s. Historical data from Index Fund Advisors shows that the S&P 600 outperformed the Russell 2000 by 1.8% annually over the 20-year period from 1994 through 2013. The S&P 600 generated an average annual gain of 11.1%, versus 9.3% for the Russell 2000.
Assuming a $10,000 investment, that difference translated into an additional $17,654 in capital gains over the period, bringing the total value of the S&P 600 investment to $81,353.
Over the last 15 years, the S&P 600 is up 348%, compared to a 310% return in the Russell 2000.
More recently, the returns are much closer. In fact, over the last five years the two indices are running neck and neck, with gains of roughly 30% each. Over the last year, the Russell 2000 has a slight edge, up 28% versus a 25% gain for the S&P 600. Year to date and over the last three months, however, the S&P 600 has regained a modest lead.
I was somewhat surprised to find that the Russell 2000 has held its own recently. Part of that strength likely reflects its greater exposure to lower-quality stocks and smaller biotech companies, both of which have performed well lately.
My suspicion is that if we check back on this performance derby a year or two from now, the S&P 600 will have pulled ahead once again.
The Bottom Line
There are ETFs that track both indices, so in my mind there is little reason for a long-term investor to choose the Russell 2000 over the S&P 600.
The S&P 600 holds higher-quality companies. It offers more earnings power for every dollar invested. And despite a recent period of relative parity, it has a long history of outperforming the Russell 2000 over time.
For investors looking for long-term small-cap exposure, the choice seems pretty straightforward.
Better companies. Better valuations. Better long-term returns.
That’s why I prefer the S&P 600.
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*This post has been updated from a previously published version.
