SPONSORED ARTICLE: The home advantage

SkylineThe largest net inflow for two decades to the small cap Russell 2000® Index occurred earlier this year. Gareth Parker, senior director, Index Research, Design & Development of Russell Investments, tells Funds Europe how this index fits into long-term portfolios and in what environment it is likely to outperform in the shorter term.

Small-cap US companies have been pacesetters this year for share price performance as belief in the US recovery gained more advocates.

The Russell 2000 Index, which is inhabited by names largely unknown outside of the US such as US Airways, had a 27.68% return at the end of September year-to-date, compared to 20.78% for the Russell 1000® Index,  which reflects large-cap companies.

Large companies have exhibited stronger performance over much of the past few years, but 2013 has marked the rise of smaller US companies, too.

With the perception of a US recovery more widely shared, the Russell 2000 Index set a number of records this year. In July, for example, it closed at a record high in each of seven consecutive trading days.

This correlation between the small-cap index performance and the US economic recovery makes perfect sense to investors who are familiar with the Russell 2000: The index’s fortunes are closely tied to those of the US because the companies that inhabit it draw more revenues from the domestic market than their larger cousins do in the Russell 1000.

Whereas 70% of revenues for the Russell 1000 index – whose large-cap members are more globalised – come from the home market, the Russell 2000 draws 84% of its revenues directly from the same market.

This divergence of revenues is part of what makes the Russell 2000 less positively correlated to the large cap Russell 1000 index and means the small-cap index should be looked upon as a diversifier for investors with US exposure, says Gareth Parker.

The diversification benefits should appeal to two types of investor: those with US, and those building global, portfolios, he says.

“A standard investor with a US portfolio likely references the Russell 1000 or another large-cap index. By allocating also to the Russell 2000 these investors are spreading their coverage of the total value of US stocks from around 80% to 98%, thereby obtaining diversification.”

Many global investors are considering diversifying from their often large-cap–focused investments into global small-cap companies. As US small cap represents some 47.7% of global developed small cap, Parker says the best geographical starting point from which to build this exposure is among the US small-cap market using the Russell 2000.

Also, 98% of investments in the US small-cap market are in, or referenced against, the Russell 2000 index family and many exchange-traded funds (ETFs) replicate the index, too. In January, nearly $800 million flowed into core small cap equities from institutional investors, the largest net inflow in 20 years.

When trading the index, such as through an ETF, Parker says investors need to consider whether they expect the US recovery to be gentle, or booming. That the Russell 2000 should rise at a time of an economic and business recovery in the US may be intuitively obvious, but research1 exists which finds greater subtlety in this.

A low rate of growth leads to outperformance of the Russell 2000 compared to the Russell 1000. The Russell 1000 outperforms when growth rates are stronger.

Given this insight, the right environment for the Russell 2000 to thrive appears to be forming. In September, when the US Federal Reserve surprised markets by postponing its expected reduction of stimulus-related asset buybacks, the Fed  also downgraded its quarterly forecasts for growth. The Fed cut its forecast for 2013 economic growth to a 2%-2.3% range from the June estimate of 2.3%-2.6%. There was an even sharper downgrade for 2014.

Among all asset classes, US small-cap equities had the strongest  inflows into global exchange traded products during the first three quarters of 2013. The Russell 2000 had a total return of 27.7% during the first three quarters of 2013 compared with 20.8% for the Russell 1000. This was the strongest first three quarters of the year for the Russell 2000 since 2003.

Trading the index is possible in a highly liquid way through ETFs, but it is the diversification benefits that will be of more interest to long-term investors.

Academic research by Rolf Banz in his 1981 paper The relationship between return and market value of common stocks, found that smaller companies over 30 years displayed higher risk-adjusted returns, on average, than larger companies.

Subsequently, and after researching the behaviour of investment managers who focus on smaller companies, Russell Investments developed the Russell 2000 Index, the first in the US small-cap field, and launched it in 1984.

Perhaps the best-known research into the small cap premium among many investors is that of Eugene Fama and Kenneth French. Their work in the early 1990s consolidated much of the earlier research and found that stocks with lower market capitalisation and higher book-to-price ratios tended to outperform, on average, over time. This research led to the Fama-French three-factor model, which extended the capital asset pricing model of William Sharpe beyond the single factor of market beta to include size and value factors in explaining expected returns.

On top of diversification and potential outperformance, the Russell 2000 also offers great liquidity, says Parker. This is because of a broad ‘ecosystem’ of financial products that have grown up around it.

This ecosystem includes active and passive institutional funds, mutual funds, ETFs, futures and options.

All combined, these developments have led to tremendous liquidity for investors seeking to gain exposure to US small-cap stocks, says Parker. In 2012, volume for ETFs, futures and options based on the Russell 2000 was far greater than for those based on either the S&P 600 or the MSCI 17502.

Volume for ETFs based on the Russell 2000 was exceptionally high, with an average daily volume traded of more than 45.7 million shares.

Small-caps are now gaining ground in the burgeoning field of ‘smart beta’ – the indices, usually referenced by an ETF, that offer one of several ‘factor tilts’ towards an academically recognised source of extra return.

For various reasons, then, the Russell 2000 has a role to play, both for long- and short-term investors. Where small companies are the pacesetters in the corporate world, the Russell 2000 will likely continue to be a pacesetter among indices.

1. The Russell 2000 Index: Small cap opportunities in a slow-growth economic environment; Koenig, David A; CFA, FRM
2. Ibid

©2013 funds europe