The role of a benchmark is to represent the return to an investment strategy in an investment universe. Active managers’ skills can be distinguished from random results by comparing their investment returns to a benchmark that represents their investment universe. In general, a benchmark represents a return to a passive strategy. If benchmarks are assumed to represent a passive strategy in a given investment universe, then returns among various benchmarks should be similar. This similarity appears to be the case in the U.S. large-cap equity universe, by looking at how the returns on the Russell 1000^® and the S&P 500^® Index closely track each other.

However, in the small-cap universe, returns between the Russell 2000 and the S&P SmallCap 600 are significantly different. Using monthly total returns from 1994¬2008, Exhibit 1 charts the growth of an investment of US$ 1 in the S&P 500 and Russell 1000, and in the S&P SmallCap 600 and Russell 2000.

Exhibit 1. Cumulative Return On Investments

Source: Standard & Poor’s, Frank Russell

In the U.S. large-cap universe, US$ 1 invested in the S&P 500 and the Russell 1000 from December 1993-December 2008 would have returned US$ 2.63 and US$ 2.67, respectively. Conversely, US$ 1 invested in the S&P SmallCap 600 and the Russell 2000 over the same investment horizon would have returned US$ 3.06 and US$ 2.38, respectively.

Since its launch in 1994, the S&P SmallCap 600 has outperformed the Russell 2000 in 11 out of the 15 years. From January 1994 through May 2009, the S&P SmallCap 600 returns exceeded those of the Russell 2000 by about 2% per year. Exhibit 2 highlights the risk/return profile of the two indices.

Exhibit 2. Risk/Return Profile

Source: Standard & Poor’s, Frank Russell. Data from January 1994 – May 2009.

The substantial divergence of returns between the two small-cap indices merits further study, and an understanding of the factors contributing to the divergence. In this paper, we examine the sources of the return differential.

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