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Investors Face Choice of Indexes To Measure Results

October 30, 1995

With Standard & Poor’s Small Cap 600 index hitting its first anniversary Tuesday it’s time for small-cap investors to take a look at how they measure their own performance. Should they continue using the Russell 2000 or switch to the S&P 600?

Standard & Poor’s entry into the small-cap index field has gained 19 percent in its first year and closed last week at 113.65. The Russell 2000 Index of small-cap stocks, the most widely used small-cap benchmark, is up 16 percent to 294.55 since last October.

The two indexes tracked each other almost identically until the technology sector took off during the summer, and the S&P outpaced the Russell. Industry experts agree that divergence in performance reflects the size and the makeup of the two indexes, but the debate continues whether those differences are strengths or weaknesses.

``The number of companies in the S&P 600 is much more manageable, and S&P has kept a more modest weighting of financial stocks than some of the other indexes,″ says Claudia Mott, a market strategist with Prudential Securities, who favors using the the S&P product as a small-cap benchmark.

The Russell has about 4 percent more small banks and financials in its index, while the S&P small cap shifts the extra percentage points into consumer services, according to Ms. Mott’s calculations. The result is that the S&P index tends to be a little more growth-oriented and thus its recent outperformance comes as no surprise.

``The S&P 600 would be a more appropriate benchmark for our growth-style investing than the Russell 2000, because many of the Russell’s financial stocks just don’t meet our growth criteria,″ says Brady Lipp, director of institutional marketing and client servicing for Warburg, Pincus Counsellors. Warburg’s small-cap funds so far have measured themselves against the Russell 2000 Growth Index and the Lipper Small Company Growth Index, both of which have been around longer than the new S&P index.

But others warn that although the S&P’s bias toward growth has boosted the index’s performance this year, that won’t always be the case. ``The S&P index is heavier than most in technology and health care, and though it helps them now it could trouble them later,″ says Theodore R. Aronson of Philadelphia-based Aronson & Fogler, an investment firm that focuses on quantitative analysis.

Although some managers question the S&P’s currently auspicious growth bent, most agree that the newer index was wise to exclude real estate investment trusts, or REITs. The Russell 2000 consists of almost 6 percent REITs, which are often partnerships owning apartment complexes, office parks or shopping malls.

``REITs are a very different-behaving segment of the market, and it’s questionable whether you’d want them in your equity portfolio,″ says Al Neubert of S&P’s index services group. ``Most managers view them as real estate outside of their equity investments.″

Russell, whose index has been around since 1979, disagrees. ``In the short term, REITs behave more like common stock than they do real estate, and we find that they are held by small-cap managers,″ counters Paul Greenwood, an analyst with Frank Russell Co., which runs the Russell indexes and tracks more than 150 smallcap money managers.

Along with the differing sector weightings of the two indexes, market experts also debate the number of companies in each.

On the ``big is better″ side, analysts say that an index using just 600 companies is too concentrated _ especially in small-cap investing _ and the performance can be skewed too easily by a few individual issues. Managers also point out that the roster of 600 companies is chosen by an S&P committee, which can be more subjective than the market often is.

But in the ``small is smarter″ camp, experts say any means of reducing trading activity and transaction costs will benefit small-cap performance. Market watchers also warn of the guaranteed volatility surrounding the Russell and many of its stocks, when the index is reconfigured every June. Often as many as 400 stocks are moved in or out of the Russell 2000, as it is reconstructed to reflect the 2,000 smallest securities in the Russell 3000 index _ the 3,000 largest U.S. securities by market capitalization. Anyone trying to match the index’s performance would incur substantial trading costs reshuffling his or her own portfolio to reflect the shift in the index.

S&P changes the components of the 600 index only when market conditions warrant, which leads to considerably less trading for investors trying to match it rather than the Russell 2000.

So, which one is right?

``As a manager or an investor, you’ve really got to take a good look at what kind of investment style you use,″ says Warburg’s Mr. Lipp. ``But most of the small-cap benchmarks give portfolio managers the discipline to stay somewhat diversified.″

As for indexing in the small-cap arena, Frank Russell Co. says that investors have parked more than $7 billion in funds indexed against the Russell 2000. Standard & Poor’s says there are a handful of funds using the 600 index, and the following is growing.

Both passive and active investors say the ability to trade options and futures on the Russell 2000 weighs in its favor. The Chicago Board Options Exchange began trading S&P 600 options last June, but trading volume has been described as ``inactive.″

``It’s important for money managers to be able to put funds to work right away, and that can be very expensive to do in small and illiquid stocks,″ explains Jill Greenwald, manager of Chase Asset Management’s Vista Small Cap Fund. ``So a lot of managers like to be able to put their money in options, which are usually very liquid and make their cash neutral to the market.″

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