The hoopla over last month’s rebalancing of the Russell 2000 small-cap index has come and gone, but the aftereffects still linger. That’s because the annual cosmetic changes have done little to reverse the Russell 2000’s stunning underperformance trend. And it has led to lackluster results for many unsuspecting exchange-traded fund investors and even their financial advisors.

One widely held fund tied to Russell’s popular small-cap benchmark, the $47.3 billion iShares Russell 2000 ETF (IWM), which is the largest small-cap equities ETF, has consistently lagged small-cap peers. During the past 10 and 15 years, the iShares Core S&P Small-Cap ETF (IJR), which tracks the S&P SmallCap 600 Index and is the second-largest small-cap equties ETF with assets of 44.5 billion, has gained 12.52 percent and 12 percent, respectively, compared to gains of 10.98 and 10.50 percent for IWM during those timeframes.

And other funds linked to the S&P SmallCap 600 Index have also outperformed IWM. The SPDR S&P 600 Small Cap ETF (SLY) has gained 13 percent during the past 10 years. It doesn’t have a 15-year track record; nor does the Vanguard S&P Small-Cap 600 ETF (VIOO), which also doesn’t have a 10-year track record. But during the past five years IJR is up 13.8 percent, VIOO is up 13.75 percent and SLY has returned 13.24 percent.

Meanwhile, IWM’s 11.6 percent gain during that period has underperformed that trio by roughly two percentage points

Put another way, ETFs linked to the S&P SmallCap 600 have trounced the largest ETF tied to the Russell 2000 in both good and bad equity markets over the past five to 15 years.

And the kicker is IWM is the most expensive product in the group with an expense ratio of 0.19 percent versus 0.15 percent for both SLY and VIOO and 0.07 percent for IJR.

What’s the root cause of the Russell 2000’s substandard results? 

One popular explanation is that FTSE Russell’s advance disclosure of changes to its Russell 2000 Index holdings allows hedge funds and traders to front run by snapping up stocks to be included in the reconstitution and then selling them afterwards for a quick profit. 

This year, for example, the newly reconstituted Russell 2000 became effective after the market close on Friday, June 22. However, on June 8 a preliminary list of portfolio holdings was publicized by Russell with two additional updates given just before and on the reconstitution date. And well before that, May is officially designated by FTSE Russell as the “ranking month” where the largest U.S. companies are designated for preliminary inclusion in Russell’s reconstituted portfolios, giving traders ample time to capitalize. (Additions and removals to the S&P SmallCap 600 Index are also announced in advance, though the lead time is just two to five days.)

Regardless, providing stock market participants with advance notice of upcoming portfolio changes plays into the hands of sophisticated traders. 

Weak screening methods for index inclusion are another contributing factor to the Russell 2000’s lackluster results. Unlike the S&P SmallCap 600, which has strict standards for index membership, joining the Russell 2000 is simply a matter of having a share price of $1 or more, a minimum market cap of $30 million and not being among the largest 1,000 stocks in the Russell 3000 Index. Moreover, around one-third of companies within the Russell 2000 aren’t profitable. Altogether, that has proved to be a less-than-favorable mix versus the S&P SmallCap 600.  

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