Why The S&P SmallCap Index Beat The Russell 2000 Index by 52%

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 ETF industry started with the stodgiest of benchmarks –
SPY – the S&P 500. 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 on MarketRiders? 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 www.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 MarketRiders: 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.