The S&P SmallCap 600 and the Russell 2000 have similar exposure to the market factor. With regards to the size premium, Russell 2000 has a slightly higher SMB coefficient than the S&P SmallCap 600, suggesting that the Russell 2000 has a higher exposure to small-cap stocks. This is to be expected, as the smallest 1000 securities of the Russell 2000 are also part of the Russell Microcap Index. The S&P SmallCap 600’s higher HML coefficient implies that the index has a higher exposure to the value factor.

The presence of a higher value premium supports the view that the S&P SmallCap 600 has an inherent valuation tilt due to its requirement that securities have four consecutive quarters of positive earnings. In order to determine if the value bias contributes to the excess return, a test was conducted to see whether a profitability criterion imposed on a market capitalization-weighted index can add alpha in the long run. To conduct the study, the universe of U.S. stocks with market capitalization between US$ 250 million and US$ 2 billion was divided into two groups:

• Group 1 consists of securities that have at least four consecutive quarters of positive trailing EPS.

• Group 2 consists of securities that do not have four consecutive quarters of positive trailing EPS.

The testing period runs from December 1993 through December 2008. To avoid survivorship bias, the Compustat^® Research (Inactive database) was used to ensure that all no-longer-existing companies were included in the test universe. To minimize the look-ahead bias, the Charter Oak Compustat non-restated fundamental data with one quarter lag was used. The holding period assumption is 12-months, and the returns are market capitalization-weighted to properly reflect the benchmark. The results are illustrated in Exhibit 9.

Exhibit 9: Impact Of Positive Earnings Screen On Performance

Source: Standard & Poor’s, FactSet. Data from December 1993-December 2008.

Group 2 underperformed the investment universe while Group 1 outperformed it, with the T-stats showing the significance of the returns at 95% confidence interval. The results confirm that securities with at least four trailing quarters of positive EPS outperformed those without positive EPS. The stock hit rate ratio is a time-series average of the number of securities within a group that have outperformed the overall benchmark return for a single day. In our analysis of the small-cap universe, 39.8% of the randomly selected stocks outperformed the overall universe during the in-sample test period on average. Securities in Group 2 only outperformed the universe 36% of the time, while securities in Group 1 achieved a stock hit rate of 47.5%, further proving that profitability as a factor provides value.

On a risk-adjusted basis, the performance of Group 1 is superior to that of the universe and Group 2. The Sharpe ratio for Group 1 is higher than the ratios for Group 2 and for the universe. The profitability criterion also results in the beta of Group 1 being lower than the average market beta. Since low beta stocks are often value stocks, it confirms our theory that the profitability screen tilts the portfolio toward a value bias. In contrast, Group 2 has higher average market beta.

The results confirm that the S&P SmallCap 600’s profitability requirement plays an integral role in the value bias, and the corresponding excess return over the Russell 2000.

Conclusion

We analyze a widely documented event in the small-cap investment universe: the S&P SmallCap 600 outperforming the Russell 2000 over the last 15 years. The analysis shows that the July reconstitution effect alone does not account for the excess return of the S&P SmallCap 600 over the Russell 2000. The remaining excess return is explained principally by inherent differences in index construction.

The July effect may moderate over time, as Russell has made enhancements to its rebalancing process to lessen its impact. For example, eligible initial public offerings (IPOs) are now added to the index on a quarterly basis. However, it would be interesting to observe if the return differential due to differences in criteria persist over the next 15 years.

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