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ETF Specialist

The Russell 2000 Index's Achilles' Heel

The index's popularity and concentrated turnover put it at a disadvantage to its peers.

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While low expense ratios make index funds appealing, indexes can incur meaningful transaction costs that are often overlooked. Changes in an index's constituents force the funds that track it to buy and sell the affected securities around the same time. These concentrated trades can move prices away from the index fund managers, creating a drag on their performance. Such market-impact costs tend to be larger among smaller-cap stocks. Here, differences in portfolio construction and the popularity of the index in question can have a noticeable impact on performance. Market-impact costs have especially plagued the Russell 2000 Index and will likely continue to put it at a disadvantage to its peers.  

The Russell 2000 Index trailed the S&P SmallCap 600, MSCI USA Small Cap, and CRSP U.S. Small Cap indexes by more than 1.4% annualized from the end of June 2001 (the first common inception date for the indexes) through January 2015. Differences in market sensitivity (beta) and size and value tilts can often explain differences in performance. But even after controlling for these effects, the Russell 2000 Index still underperformed by 1.51% annualized (its alpha). In fact, it was the only one of the four indexes that exhibited a statistically significant negative alpha. This may be because the Russell 2000 Index is one of the most widely followed U.S. small-cap indexes and reconstitutes itself on a single day each year. The resulting trading volume in the stocks that the index's reconstitution affects could cause it to suffer from greater market-impact costs than its peers.

Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.