The Russell 2000: An Earnings Illusion

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It may seem odd to hate a stock index. After all, it’s just a model of company shares used by fund managers to build ETFs and mutual funds.

But once you learn the truth about the Russell 2000 small cap index, you just might hate it too.

Today we’re going to explore why the Russell 2000 makes a bad foundation for any investment vehicle.

Misleading Stats (at Best)

Historically, small cap stocks tend to outperform large ones. This hasn’t been the case over the past decade, but if we go back further in time, it generally holds true over long periods.

Today, tens of millions of Americans get their small cap exposure through the Russell 2000. It’s the most widely-owned small cap index, and if you hold any target-date retirement funds, you probably have a stake in it.

But the Russell 2000 is a fundamentally flawed index. Allow me to explain why.

Let’s look at the largest ETF based on the Russell 2000, iShares’ IWM fund. This is a massive ETF with more than $62 billion of assets.

If you look at IWM’s website, it advertises a P/E ratio of 16. That’s not bad, around the historical norm. At 16, the index would be fairly priced for a collection of small cap stocks.

But there’s an asterisk beside that ratio. If you click it, it tells you the following:

“Negative P/E ratios are excluded from this calculation”.

Now why would they do that? The purpose of a fund telling you its P/E ratio is to inform the investor about how expensive stocks in the fund are. If you throw out all the companies losing money, it’s no longer a true representation.

Making the situation worse, fully 42% of Russell 2000 companies were losing money as of last September. So roughly 42% of the fund is not included in the advertised P/E ratio. According to the Wall Street Journal, the true P/E ratio of the Russell 2000 is 34. That’s more than twice as expensive as the claimed number!

And it seems to be getting worse over time. Research by FS Investments shows that over time the percentage of companies in the Russell 2000 which are losing money is rising.

Source: FS Investments

As you can see, of companies in the Russell 2000 which IPO’d between 2020 and today, nearly 70% are losing money.

During a downturn, the Russell 2000 could fall sharply due to the fact that 42% of its companies are losing money. In tough economic times, profitable companies tend to outperform, especially if they can maintain a dividend.

A Better Alternative

If you want U.S. small cap exposure to your portfolio, fortunately there’s a much better option than the Russell 2000.

The S&P 600 small cap index is superior in just about every way. The largest ETF based on it is SPSM. It sports a lower expense ratio, at just 0.03% net. That’s incredibly cheap.

And unlike the Russell 2000, the S&P 600 has a profitability screen. It only accepts companies that are making a profit, and periodically reviews constituents to ensure they’re not hemorrhaging cash.

According to Morningstar’s fund comparison tool, over the past 5 years the S&P 600 has returned 11.4% per year, outperforming the Russell 2000’s 9.75% return.

So, why is the Russell 2000 index more popular than the S&P 600? It’s a mystery. Maybe they have a better marketing and sales team? Just a guess.

Over time I expect that quality will win out, and the S&P 600 will surpass the Russell 2000 as the standard small cap index. But that could take quite a while, based on the fact that the Russell is so firmly embedded in today’s investment landscape.

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