When investors refer to “the stock market,” they usually mean a broad swath of company shares, often represented by the famed Standard & Poor’s 500 Index, or its older, perennial alternative, the Dow Jones Industrial Average.
While the S&P 500 and Dow track big U.S. companies, another useful index is the Russell 2000, which gauges the fortunes of smaller companies—a vital yet frequently overlooked component of the U.S. capital markets.
What is the Russell 2000?
The Russell 2000 Index tracks 2,000 or so of the smallest publicly traded U.S. companies as measured by market capitalization—a company’s stock price multiplied by its total shares outstanding. The index is overseen by FTSE Russell, an indexing company owned by the London Stock Exchange.
The Russell 2000’s holdings are distributed across industries. As of March 2022, health care was the biggest, with about 16.3% of the index, followed by financial services at 15.5%, industrials at 15.1%, technology at 13.5%, and consumer cyclical at 10.3%.
Sometimes companies outgrow the index, are acquired, or otherwise disappear, leading FTSE Russell to update the Russell 2000 annually, admitting new members and tossing out others.
Each May, FTSE Russell begins determining which companies to add and delete, based on market cap and other factors. In June, the company begins communicating to the market the status of its work and announces the reconstitution of the index at the end of that month.
FTSE Russell subindexes
Wall Street likes to slice the small-cap market further. So FTSE Russell created a variety of subindexes.
The smallest 1,000 stocks in the Russell 2000 are peeled off to create the Russell Microcap Index. The Russell 2500 Index is the Russell 2000 plus the next largest 500 stocks, giving investors exposure to bigger companies that may have outgrown the basic benchmark.
Based largely on constituent companies’ price-to-book value ratios, a measure of their relative priciness, as well as several earnings and sales growth metrics, stocks are also allocated to the Russell 2000 Growth and Value indexes.
The Russell 2000 is also divided into Defensive and Dynamic subindexes, which are more or less sensitive to the economic cycle by using factors like earnings and price volatility, return on assets, and debt.
The Russell 2000 vs. S&P 500: key differences?
As a small-cap index, the Russell 2000 index looks at a different universe than its rivals. The median market cap of a Russell 2000 company is just $1 billion as of Feb. 28, 2022, compared to $31.3 billion for the median S&P 500 member. There are other important differences as well.
Distribution and diversification
Because of the large number of stocks in the Russell 2000, each makes up a tiny portion of the total. The top 10 stocks account for just 3% of the Russell 2000’s total value. By contrast, the top 10 stocks in the S&P 500 comprise 28% of the benchmark’s valuation.
While health care, financial services, and industrials represent the top industries on the Russell 2000, the S&P 500 is weighted toward tech, which amounted to more than 25% as of March 2022. Health care followed with 13.9%; financial services, 13.3%; consumer cyclical, 11.4% and communication services, 9.5%.
So the small cap index is more diversified by industry than its alternatives. “It’s pretty well split between financials, health care, consumer,” says Myles Udland, a Titan strategist. “And it’s a lot less tech-heavy.”
Exposure to the US economy
Given the abundance of multinationals in the S&P 500, some 40% of the sales of its companies are from abroad. The comparable foreign sales figure for the Russell 2000 is a fraction of that.
“The companies in the Russell 2000 have more exposure to the domestic U.S. economy,” says strategist Udland. And they are less likely to be affected by currency swings as well.
The indexes diverge in terms of valuation, as measured by their price-to-earnings (P/E) ratios, which compare what investors pay for a company’s shares relative to its per-share profit. As of March 2022, the Russell 2000 traded at a relatively modest forward P/E of 13.6—much less than the 19.6 of the S&P 500.
The Russell 2000 is riskier than indexes made up of bigger companies. As measured by its standard deviation—how much the index price varies around its mean—the small-cap is 25% more volatile than the S&P 500.
Practically speaking, that means that during downdrafts like the sudden two-month bear market in February and March 2020 at the onset of the coronavirus pandemic, the Russell 2000 was hit much harder, falling 28.3% compared to a 19.5% drop for the S&P 500. On the other hand, in 2003, the year after the bottom of the dot-com crash, the Russell 2000 returned a sizzling 46.9% versus 28.4% for the S&P 500.
Longer term results of the Russell 2000 vs. S&P 500
For the 10 years ended on March 4, 2022, the Russell 2000 posted an annualized return of 11%. So an investment of $10,000 a decade ago would have grown to more than $28,000.
But the S&P 500 generated a 10-year annualized return of 17.6% Which would have spurred the growth of a $10,000 investment to $37,476.
With such a disparity in performance, why pay attention to the laggard Russell 2000? Because sometimes the performance advantage favors smaller companies.
In the past decade, the Russell 2000 has soundly trounced the S&P 500 in two of the last ten calendar years, besting its rival 37.4% to 31.5% in 2013 and even more so in 2016, 20.8% to 10.4%. But the small-cap index badly trailed its big company rival in 2018, losing 12.7% versus a loss of less than half that, 6.3%, for the S&P 500.
There’s some evidence that small caps beat large caps long term, bolstered by the academic theory that the markets need to compensate investors for the extra risk in diminutive companies. Much depends on the time periods examined.
The Russell 2000 vs. the Nasdaq
The S&P 500 isn’t the only rival to the Russell 2000.
The Nasdaq Composite Index is a market-cap-weighted roster of stocks on the Nasdaq Stock Exchange. Investors use it mainly to track tech stocks, because so many of them are listed on the electronic marketplace: tech companies comprised 43.9% percent of its value as of March 2022. A further 15.8% of its holdings are classified as communications services, including Netflix.
The top companies in the Nasdaq index are Apple, Microsoft, Amazon, Tesla, and the class A and B shares of Google parent Alphabet—the same top holdings as the S&P 500.
The Russell 2000 as of March 2022 includes no blue chips. The top five stocks were oil and gas producer Ovintiv; hospital operator Tenet Healthcare; Chesapeake Energy, an exploration and oil producer; engineering firm Tetra Tech; and theater operator AMC Entertainment.
These are followed by semiconductor maker Synaptics; food-services distributor Performance Food Group; EastGroup Properties, a real estate investment trust; engineering firm KBR; and Macy’s, the beleaguered retailer.
How to invest in the Russell 2000
An investor can build a portfolio that reasonably resembles the S&P 500, Dow, or Nasdaq Composite by buying and holding a dozen or two of the largest companies. That’s not practical for the small-cap index with its thousands of diminutive members. ETFs and mutual funds can do this work for an investor, though.
Mutual funds that track the index include the MM Russell 2000 Small Cap Index, Rydex Russell 2000, Schwab Small Cap Index, Voya Russell Small Cap Index Portfolio, and the iShares Russell 2000 Small-Cap Index.
Two big exchange-traded funds, the iShares Russell 2000 ETF and Vanguard Russell 2000 ETF, also track the benchmark.
The Schwab Small Cap Index fund charges just four hundredths of a percentage point while the Rydex Russell 2000 A shares carry expenses of 1.67%.
The bottom line
The Russell 2000 is a useful tool for investors who want to profit from the stock market aside from the big, well-known companies whose names are so familiar. It gives investors an opportunity to hold a stake in the smaller companies that sometimes outperform their bigger brethren, while also offering more exposure to the performance of the U.S. economy.