Small Cap Indexes

By Financially Fit Staff

Stock indexes are important for many reasons, including the fact that they:  

1) provide a gauge for how the market is performing  

2) provide a standardized basis for investors to compare mutual funds and money managers (professional money managers are often measured on relative performance versus an index, and not in terms of absolute returns)  

3) allow investors to evaluate their investment risk, and  

4) provide an alternative to active money management. 

The Russell 2000, a subset of the larger Russell 3000, by way of how it is constituted includes many newer, smaller firms often not represented by the S&P 500 or other large indices. On this basis, it is used both as a barometer and the benchmark in the small cap world.  

Each year the largest 3,000 U.S. companies are ranked according to market capitalization by the folks at Russell Investment Group, a subsidiary of Northwestern Mutual Life Insurance Company. Of these 3,000 companies, the largest 1,000 form the Russell 1000 index, and the remaining 2,000 form the Russell 2000.  While it contains twice as many stocks as the large-cap Russell 1000, because of their much smaller size, the Russell 2000's component stocks account for just 8% of the total market capitalization of the Russell 3000 Index.

The value of the index is based on a market cap weighting, meaning that the largest constituent stocks have the greatest affect on the index's performance. However, the Russell 2000 is much more evenly weighted than other indexes because the top ten holdings account for less than 2% of the index's overall value.  Further, the average firm has a market cap of about $763 million, with most firms in the index ranging in size from approximately $220 million to $2 billion. This varied sampling provides a broad assessment of the small cap universe.

Why is the Russell 2000 so pertinent? 

In addition to its obvious role as the barometer for small cap stock performance, since its inception in 1984, the Russell 2000 has easily outperformed its large-cap peers.  And due to its popularity, and negligible trading fees and liquidity that come in tandem with that fact, many investors actively trade this index. This means the active money managers also use the index as part of their hedging strategy.

To long-term investors such as ourselves, the Russell 2000 serves the purpose of keeping our investing strategies in check.  If investors are pulling out of small caps in droves, we'd be quite foolish to step in front of this wave.  Likewise, it could prove to be a good idea to identify the movement of money into the small cap universe, and time our fundamentals-based purchases accordingly.  Another index to follow in this manner is the S&P SmallCap 600, published by Standard & Poor's, a division of the McGraw-Hill Companies.

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


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