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A Review Of Index Mechanics
While both the Russell 2000 and the S&P SmallCap 600 Indices measure returns on a passive investment, the index mechanics between the two differ substantially.
The Russell 2000 represents 2000 U.S. companies based on their market capitalization. The index is reconstituted annually at the end of June. Securities are ranked according to their market capitalization as of the last trading of May, and those with rankings of 1001 to 3000 are included in the Russell 2000. The unambiguous nature of the index’s construction implies that market participants can anticipate the changes and can, therefore, trade accordingly.
In contrast, the S&P SmallCap 600 implements changes on an as-needed basis. To be eligible for inclusion, constituents must meet market capitalization, liquidity, public float, GICS® sector representation and profitability measures. Constituent deletions occur due to bankruptcy, mergers, acquisitions, significant restructuring or substantial violation of one or more of the eligibility measures. Since Standard & Poor’s does not follow a purely mechanical approach, additions and deletions are less predictable and have more of an ability to impact prices compared to the Russell 2000.
Exhibit 3 highlights the methodology differences between the two indices.
Exhibit 3. Index Construction Differences
Source: Standard & Poor’s, Frank Russell
Impact Of Reconstitution
Many studies have been conducted on Russell’s annual reconstitution process in June, particularly regarding the downward price pressure exerted by the reconstitution. As winners from the Russell 2000 graduate to the Russell 1000, and losers from the Russell 1000 move down to the small-cap universe, active managers are forced to sell winners and buy losers, thereby creating a negative momentum portfolio (Furey 2001). Jankovskis (2002) and Chen, Noronha and Singal (2006) estimated that the predictable nature of the June Russell rebalancing process biases the return of the index downward by an average of approximately 2% and 1.3% per year, respectively.
Our analysis of the S&P SmallCap 600 monthly excess returns versus the Russell 2000 reveals a similar finding. The analysis examined the average monthly excess returns from January 1994 to May 2009, and noted that the monthly excess returns for July are higher than that of any other month.
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