The Russell 2000 Index's Achilles' heel

The index's popularity and concentrated turnover put it at a disadvantage to its peers.

Alex Bryan 28 April, 2015 | 5:00PM

While low expense ratios make index funds appealing, indexes can incur meaningful transaction costs that are often overlooked. Changes in an index's constituents force the funds that track it to buy and sell the affected securities around the same time. These concentrated trades can move prices away from the index fund managers, creating a drag on their performance. Such market-impact costs tend to be larger among smaller-cap stocks. Here, differences in portfolio construction and the popularity of the index in question can have a noticeable impact on performance. Market-impact costs have especially plagued the Russell 2000 Index and will likely continue to put it at a disadvantage to its peers.

The Russell 2000 Index trailed the S&P SmallCap 600, MSCI USA Small Cap and CRSP U.S. Small Cap indexes by more than 1.4% annualized from the end of June 2001 (the first common inception date for the indexes) through January 2015. Differences in market sensitivity (beta) and size and value tilts can often explain differences in performance. But even after controlling for these effects, the Russell 2000 Index still underperformed by 1.51% annualized (its alpha). In fact, it was the only one of the four indexes that exhibited a statistically significant negative alpha. This is because the Russell 2000 Index is one of the most widely followed U.S. small-cap indexes and reconstitutes itself on a single day each year. The resulting trading volume in the stocks that the index's reconstitution affects could cause it to suffer from greater market-impact costs than its peers.

While most changes to the Russell 2000 Index go into effect toward the end of June, investors know what changes to expect at the end of May. That's the date Russell uses to assign the largest 1,000 stocks to the Russell 1000 Index, and the next 2,000 largest to the Russell 2000 Index. There is a small buffer to limit unnecessary turnover between the two indexes. Because Russell 1000 indexers take the other side of the Russell 2000 trades when stocks cross the threshold between the two indexes, these additions and deletions may have a smaller market impact than movements across the Russell 2000 Index's lower bound. However, stocks near the cut-off receive a much larger weighting in the Russell 2000 than in the Russell 1000.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.

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