The Superiority of the Russell 2500 Over the Russell 2000

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Small caps have been outperforming large caps. Small-cap value stocks, for example, just had their seventh best-ever quarterly return by posting gains of over 21%, as measured by the Russell 2000 value index. This came after they posted their best-ever quarter a year ago, with a 33.4% return in the second quarter of 2020.

Can small-cap value this keep up?

Periods like the one just experienced historically portend well for the relative returns of small-cap value stocks. According to Furey Research, when value has a strong two-quarter relative performance, it outperforms growth by 7% on average the following year.

For investors wanting to capture outperformance in small-cap stocks, here’s a warning. Soon, some of the biggest winners among small caps will “graduate” out of the Russell 2000 index (and by extension its value and growth sub-indexes) when Russell conducts its annual rebalancing this summer. At that point, those winners will no longer be the largest among their cohorts. They’ll be midcaps and will be lumped in with companies that have been midcaps for decades.

Here’s a simple visual on what happens to a “graduate” of the Russell 2000 index:

Before graduation, a small cap is a much larger percentage of Russell 2000 than it is of the Russell midcap or more so the Russell 1000.

Because investors keep relatively fixed portfolio allocations to small, mid, and large-cap companies, the typical effect of graduation from the Russell 2000 is to reduce these winners’ importance to the overall portfolio.

That’s like a baseball team trading away its all-stars year after year and replacing them either with rookies (much smaller companies) or former midcaps that have slipped back (aging veterans).

Intuitively, you’d expect there to be a performance advantage in giving your winners room to run before reducing their relative size in a larger portfolio. One way to do that is to adopt the Russell 2500 index instead of the Russell 2000 index as the reference point for small-cap investing.