From May 2000 through May 2008, the S&P SmallCap index (IJR) is up over 50% from its competitive index the Russell 2000 (IWM).  Both indices, IJR (S&P 600 SmallCap Index) and IWM (Russell 2000 Index) purport to give an investor exposure to small cap stocks in the US stock market.  The average market caps are similar and many of the same companies exist in each index.  But why does IJR do so much better than IWM?

The S&P 600 SmallCap Index Beats the Russell 2000 by 52% over 7 Years*

*dividend adjusted.  Information from Yahoo Finance. 
 

The ETF industry started with the stodgiest of benchmarks –  the S&P 500 (SPY).  But today, there are over 700 indexes so the term “benchmark” is now a lot less meaningful.  Friday’s opening of the famous “Russell Trade” got me to take a step back and assess – where are we going with our discussions regarding ETFs for Asset Allocation, on Seeking Alpha?  Which ETFs are dangerous and why?  Where can an investor get stung, even with ETFs?   

I avoid Russell indices like the plague and so should anyone building an ETF portfolio that they want to hold for a long time.  On MarketRiders.com, we don’t use them in our free template portfolios.  The have tremendous shortcomings, namely the way the indices are constructed.  Why?  The Russell 2000 is rules-based.  Every May 31^st, the smallest 2000 securities in size below the largest 1000 securities, are rank ordered by market capitalizations.  Those that make it each year are kept in and those companies that suffered are booted off.  This creates an enormous turnover rate averaging around 25% each year that creates taxable income for investors.   

Worse yet, the rules-based process for the annual reconstitution, creates another cost for investors.  As David Swensen so aptly described in Unconventional Success: 

As the May 31^st date of capitalization ranking nears, sharp-witted arbitrageurs identify those securities most likely to enter or exit… the index.  Knowing that index managers mechanistically buy new joiners and mindlessly sell old exiters, the arbitrageurs buy the stocks likely to enter and sell the stocks likely to leave.  When the July reconstitution occurs, the arbitrage activity causes the index fund manager to pay more for purchases and receive less for sales.

To illustrate Swensen’s point, I’ve posted a copy of a report on MarketRiders from an investment bank detailing the 2008 “Russell Trade” to illustrate how professional money managers are about to game the system.  For example, 157 stocks are expected to leave the Russell 2000 and 259 will be added.  For money manager who want to use this strategy to make money in the next month, the piece suggests buying small companies with low volume that will be added to the index like Griffin Land and Nurseries (GRIF) or Ames National Corp (ATLO) where the number of shares that index fund and ETF provides will need to buy to rebalance their Russell 2000 products will be equal to hundreds of days of trading volume.  (In fair disclosure, I’m holding Intersections (INTX) just for this “trade” and will sell it on July 1^st)  

In contrast, S&P, while its SmallCap index holds many of the same companies, but uses, in Swensen’s words, “a committee-based, moderate-turnover approach to selection stocks.”  In other words – no one knows what the committee will let in and out of the benchmark and when so its impossible to “game.” 

In summary -- for a small cap mutual fund manager, the Russell 2000 index is an excellent benchmark.  For the rest of us, investing in it is not the smartest thing to do.   

All of this raises a broader question that I would hope more of us can discuss on Seeking Alpha:  What defines a superior index?   While its interesting that every company except for Walmart is now issuing new ETFs, I’m hoping we can all explore whether they belong in a portfolio and if so, what kind.  I’d like to know from more of you what you think is a good index for a permanent ETF portfolio that I would hold for my entire life, and why. 

Disclosure: Author holds a position in IYR (and INTX, as mentioned within the article).

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Mitch Tuchman

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