Five years ago, S&P Dow Jones Indices published a research paper (Soe and Dash 2010) that examined the return differential between two of the leading U.S. small-cap benchmarks, the S&P SmallCap 600® and the Russell 2000®. The original paper attributed the main source of return differential to the inclusion of a profitability factor, leading to the S&P SmallCap 600 consistently outperforming the Russell 2000 on both an absolute and risk-adjusted basis. This paper aims to revisit this topic to see if the results have continued to hold true. In addition, it extends the original research by examining the effect that benchmark selection can have on performance measurement.
Indices play a multifaceted role in portfolio management. For passive investors, indices can underlie investment products, which provide exposure to an investment strategy in a given investment universe or market segment. For active investors, indices are used as benchmarks in order to compare the returns of an actively managed portfolio to that of an index representing the investment universe or style of the active portfolio. Benchmarks may also serve as proxies for asset class returns in formulating policy portfolios. Thus, a benchmark in a particular asset class or subclass serves not only as a point of comparison but also as a determinant in assessing the value of active management.
If benchmarks are assumed to represent a passive strategy in a given universe, then the risk/return profiles among various benchmarks in the same universe should be relatively similar in nature. This similarity appears to be borne out in the U.S. large-cap equity universe, as shown when comparing the returns of the Russell 1000® and the S&P 500®. Using monthly total returns from 1994 to 2014, Exhibit 1 charts the growth of a hypothetical investment of USD 1.00 in the S&P 500 and the Russell 1000, as well as in the S&P SmallCap 600 and the Russell 2000. In the U.S. large-cap universe, USD 1.00 invested in the S&P 500 and the Russell 1000 from January 1994 through December 2014 would have returned USD 6.63 and USD 6.80, respectively. However, in the small-cap universe, the returns of the Russell 2000 and the S&P SmallCap 600 are considerably different. An investment of USD 1.00 in the S&P SmallCap 600 over the same time period would have returned USD 8.59, while it would have returned USD 6.18 if invested in the Russell 2000.