Why Savvy Investors are Undaunted by Weak Small-Cap Index

How One Flawed System Devalues Small-Cap Stocks Unnecessarily

Coins and Bills

If you were to follow the Russell 2000 Index—the world’s best-known benchmark of small-cap stocks— you might notice that small caps, as an asset class, are underperforming.

This data is frustrating, because it implies to the everyday investor that small-cap stocks are not a wise investment.

And at an index level it’s true … small-cap stocks are stuck in the mud.

But nothing could be further from the truth when you look at a narrower subset of small-cap stocks: mainly technology, biotech and MedTech stocks. The performance of these small-cap stocks is off the charts!

Bottom line – the average investor who doesn’t look any deeper than small-cap index performance is missing out on all the great small-cap growth stocks of today, which will likely become the mid-cap stocks of tomorrow.

And they don’t need to.

Why the Russell 2000 is Not a Good Indicator

There are a lot of ways we can unpack why small caps are underperforming. But given time and space constraints I’m mostly going to rail against the Russell 2000 Index in broad generalities.

For those that don’t know, the Russell 2000 is a group of 2,000 small market-cap stocks that FTSE Russell decides are most relevant each year.

Their pitch is that this market cap constrained methodology removes subjectivity and increases transparency, so index investors get an index that’s “representative, reliable and relevant.”

There are three current underlying issues with the Russell 2000 Small Cap Index that I see.

First, there’s no real type of quality screen. Sure, removing subjectivity from index stock selection is great, if the subjective opinions of decision makers is dreadful.

But if subjective opinions are good, that’s what you want! The Russell 2000 doesn’t allow for good, subjective stock additions and deletions.

Second, there’s the upward migration issue. Growth investors know that good stocks go up! If all the good small-cap companies are getting bigger where’s the incentive to blindly purchase a basket of 2000 smaller companies? Especially when upward migration – which happens when companies that get too big for the Russell 2000 are removed from the index – takes away all the best-performing companies?

It would be one thing if the IPO market refreshed the index at the low end with a constant stream of new blood. But from what I’ve seen IPOs are getting bigger, not smaller.

While there are a lot of good companies that enter the small-cap index each year, they are dwarfed by the sheer number of stocks that don’t perform well.

The S&P 500 doesn’t suffer from this upward migration issue. A great growth stock can keep going up, and that performance won’t lead to its eventual removal from the index.

And third, the world, and the stock market, is changing. The emergence of new technologies, like cloud computing, are driving massive changes. One of those changes is that the strong are getting stronger as these businesses scale up more rapidly than businesses of yesteryear.

Why the S&P 500 is a Better Indicator

Much of that performance is being captured in the S&P 500. The S&P 500 holds five of the most successful technology companies in history, and they don’t need to leave the index. Ever.

In comparison, the Russell 2000 holds one tech stock in its top 10 positions, and if and when it gets too big, it will leave the index.

How can the Russell 2000 ever compete?

There are a lot of other nuances we could talk about when comparing relative attributes and performance of the Russell 2000 and S&P 500. But is it worth the time and effort?

I don’t think so. Which is why I find myself spending less and less time looking at the small-cap index, and its performance. Unless it’s to bash it.

As currently constituted, the Russell 2000 Index holds zero allure for growth investors, in my humble opinion.

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