Small-cap trackers show why your choice of benchmark can make a large difference to long-term returns
Cris Sholto Heaton Investment columnist
Last week, we saw that the small-cap effect was more inconsistent than many investors assume. Smaller stocks have beaten larger ones over decades, but they have oscillated between long spells of outperformance and underperformance. In recent years, they have seen a long streak of underperformance. That doesn’t mean that we should ignore small caps, but we should think about whether this is likely to persist and why.
However, before getting that far, investors who want to track small-cap indexes need to consider what they are buying. We can see this most clearly in the US, where there is a choice of competing small-cap indexes.
Look beyond the obvious in America
The best-known US small-cap index – and the one with the most assets in UK-listed exchange traded funds (ETFs) – is the Russell 2000. This covers the 2,000 smallest stocks in the Russell 3000, which is FTSE Russell’s whole-of-market US benchmark. As this implies, there is a Russell 1000 index of larger stocks, which gets little attention – all the focus at the larger end of the market is on the S&P 500 index. In turn, the S&P 500 is one of three benchmarks in its own series, alongside the S&P MidCap 400 and the S&P SmallCap 600, which are often ignored in favour of the Russell 2000.
Add all these numbers up and you can quickly see that while both the S&P 600 and Russell 2000 are viewed as small-cap proxies, they will have different market coverage. There is overlap, but some stocks will be in one and not the other.
Still, the most critical difference between the two is something less obvious. S&P requires a stock to have been profitable for four quarters before being added to the index (although not to stay in it), while FTSE Russell has no such requirement. This acts as a v
