Indices play a multifaceted role in investment management. Passive investors use indexed-linked investment products to gain exposure to particular investment universes, market segments, or strategies. Active investors use indices as benchmarks to compare actively managed funds to indices representing the active portfolio. Indices can also serve as proxies for asset class returns in formulating policy portfolios.
If indices can represent passively implemented returns in a given universe, then the risk/return profiles among various indices in the same universe should be similar. In large-cap U.S. equities, the S&P 500® and Russell 1000 have had similar risk/return profiles (9.65% versus 9.73% per year, respectively, since Dec. 31, 1993). However, in the small-cap universe, the returns of the Russell 2000 and the S&P SmallCap 600® have been notably different historically. Since year-end 1993, the S&P SmallCap 600 has returned 10.44% per year, while the Russell 2000 has returned 8.78%. In addition, the S&P SmallCap 600 has also exhibited lower volatility (see Exhibit 1).
A study performed by S&P Dow Jones Indices (S&P DJI) in 2009 (Dash and Soe) showed that return differences were primarily due to the inclusion of a profitability factor embedded in the S&P SmallCap 600. A later update of the study in 2014 (Brzenk and Soe) confirmed the continuing existence of the quality premium.
This paper renews the study now that 10 years have passed since our original paper. In addition to the profitability criteria, we also extend the analysis to two additional index inclusion criteria—liquidity and public float—that are present in the S&P SmallCap 600 but absent in the Russell 2000. Our paper shows that all else equal, U.S. small-cap companies with higher profitability, higher liquidity, and higher investability tend to earn higher returns than those with lower profitability, liquidity, and investability. Observed together, these characteristics explain the potential performance advantage of the S&P SmallCap 600.