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From December 1993 to December 2008, an investment of US$ 1 in the Russell 2000 and the hypothetical Russell 2000 would have yielded US$ 2.38 and US$ 2.73, respectively, while the same investment in the S&P SmallCap 600 would have returned US$ 3.06.
The difference between the Russell 2000 and the S&P SmallCap 600 amounts to US$ 0.67, while the difference between the hypothetical Russell 2000 and the S&P SmallCap 600 is US$ 0.34. Therefore, approximately half of the excess returns may be attributable to the reconstitution effect, with the other half stemming from factors other than reconstitution.
Performance Attribution
Performance attribution attempts to explain the sources of a portfolio’s performance relative to its benchmark over a specific period of time. One of the widely used performance attribution models is that proposed by Brinson and Fachler (1985), in which the sources of a portfolio’s active return are broken into three components:
(1) Allocation effect – the portion of the portfolio’s excess return attributable to over- or under-weighting of securities in a particular grouping (country, sector, beta etc.) relative to the benchmark.
(2) Selection effect – the portion of the portfolio’s excess return attributable to selecting different securities within each group from the benchmark.
(3) Interaction effect – the portion of the portfolio’s excess return attributable to combining the allocation effect with the selection effect.
Using the multi-period Brinson attribution model, we analyzed the S&P SmallCap 600 excess return relative to the Russell 2000. By evaluating in this framework, the analysis seeks to understand whether a particular grouping explains the sources of S&P SmallCap 600 active return.
The study used the daily total returns of the two indices from 1994-2008. The returns are grouped into the following three categories:
1. Sector - as defined by the Global Industry Classification Systems (GICS®)
2. Size - as defined by market capitalization
3. Valuation - as defined by P/B ratio
Exhibit 7 below summarizes the results, which represent the average annual effect of each component of performance attribution. The results of sector-based attribution are particularly interesting. They indicate that the sector allocation differential between the S&P SmallCap 600 and the Russell 2000 does not account for much of the return difference, contributing only 0.22% out of the 1.92% excess return. Most of the excess return stems from the selection effect or the composition within each sector. When grouping by market cap and price/book, allocation and selection effects appear to contribute equally to the excess return, with no single effect dominating the other.
Exhibit 7: Performance Attribution
Source: FactSet. Data from January 1994-December 2008.
Groupings by size and valuation within the performance attribution framework do not provide conclusive evidence as to whether the S&P SmallCap 600 has size or valuation exposure. The attribution results only indicate that under- or over-weight positions in size and valuation groupings explain much of the excess return. To further explore the impact of size and valuation, the Fama-French Three Factors model was examined.
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