David Koenig serves as Investment Strategist on the Research and Innovation team for Russell Investments’ family of global indexes. In this email interview with SmartBrief, Mr. Koenig talks about the development of indexes and how the process has changed over time.
Question: What are the potential benefits of including small cap stocks in an investment portfolio?
David Koenig: Significant investigation into what is now commonly referred to as the “small cap risk premium” has shown that small cap stocks have distinct risk-return characteristics that may provide diversification benefits and potentially enhance returns over time.
Among the earliest research was a 1981 paper by Rolf Bänz, which found that “smaller firms have had higher risk-adjusted returns, on average, than larger firms.” Bänz referred to this performance difference as a “size effect.” And of course perhaps the best-known research into the small cap premium is that of recent Nobel Prize winner Eugene Fama and research partner Kenneth French. Their work in the early 1990s consolidated much of the earlier research and found that on average, stocks with lower market capitalization and higher book-to-price ratios tend to outperform over time. This research led to the Fama-French three-factor model, which extended the capital asset pricing model (CAPM) of William Sharpe beyond the single factor of market beta to include size and value factors in explaining expected returns.
Q: Russell Investments has a long heritage of leadership in the U.S. small cap equity market segment. What led to the development of the Russell 2000? How has investor use of the index changed over time?
DK: This is a great time to talk about the Russell 2000® Index as it celebrates its 30th anniversary in 2014. With the introduction of our U.S. index series in 1984, Russell Investments was the first index provider to develop an investable broad market index that could be divided into individual size segment indexes. We recognized that investors needed more precise indexes than existed at that time to better measure markets and assess investment manager skill.
We understood that not all investment managers exhibited the same behavior, with some focusing on larger companies and others on smaller companies. That insight led us to develop the broad Russell 3000 Index and its size components, the Russell 1000 Index of large cap stocks and the Russell 2000 Index of small cap stocks. Since that time, investors have overwhelmingly embraced the Russell 2000 as their small cap index of choice for measuring the small cap market segment, and serving as the basis for active and passive small cap funds. Of all actively managed U.S. equity small cap mutual funds and separate accounts, 98% of institutional products and over 99% of institutional assets are benchmarked to the Russell 2000 small cap family.
One reason for this broad success is that the Russell 2000 is designed to offer a comprehensive and objective representation of the U.S. small cap market, which makes it an efficient building block for accurate asset allocation. Based on the principle of comprehensive coverage, the Russell 2000 Index includes the 2,000 smallest U.S. companies by market cap in the Russell 3000® Index, representing about 8% of the U.S. equity market. This unbiased ranking of stocks by size results in an index that comprehensively represents the small cap market.
Q: What are the performance dynamics between small cap and large cap stocks?
DK: Small cap stocks remain a component of well-constructed, diversified multi-asset portfolios. Whether a small cap premium continues to exist, and how strong it will remain, continue to be the subject of much academic debate; however, small cap stocks have historically provided an important source of diversification within an investment portfolio. This is evident in the shifts in performance leadership between small cap and large cap stocks over time. Over the 35-year period from 1979 through 2013, small caps outperformed in 18 years while large caps outperformed during 17 years. These performance cycles tend to be somewhat cyclical in nature.
Although small cap and large cap stock returns have historically exhibited relatively high correlation, indicating that they tend to move in the same direction, correlations can vary significantly over time. It is worthwhile to note that over the 35-year period, small cap and large cap stocks actually moved in different directions 23% of the time. And correlation fails to tell the whole story, as small cap and large cap stocks have historically tended to move at meaningfully different magnitudes.
Q: U.S. small cap stocks had exceptionally strong performance in 2013. What do you think might have led to that strong performance?
DK: Institutional interest in small cap U.S. stocks surged in 2013, in an apparent sign that sophisticated investors are growing more confident about the durability of the U.S. economic recovery. January 2013 saw the largest monthly net inflows into the Morningstar small cap core category in at least 20 years, and flows into the category were positive every month during the year for the first time since 2005. Among U.S. listed exchange-traded products, U.S. small cap equities had one of the strongest net flows among asset classes in 2013 at approximately $15.6 billion.
The Russell 2000 had a total return of 38.8% for the year, outperforming the Russell 1000 by more than five percentage points. That was the Russell 2000’s strongest annual performance since 2003 and one of its strongest ever annual gains, exceeding 35% only four other times since 1979. In years after those previous robust advances, returns were positive in every year, providing double-digit returns in three of these years, and ranging from as high as 38.6% in 1980 to just 2.0% in 1981.
U.S. small cap stocks are closely connected to the U.S. economy, with Russell 2000 Index companies generating approximately 84% of their revenue within the U.S., versus 70% U.S. revenue for Russell 1000 companies. 2013 provided an environment for strong gains, as moderate growth centered in the U.S. supported U.S. small cap stocks. U.S. small cap stocks benefited as the U.S. economy strengthened over the course of 2013 and showed signs of transitioning from recovery to expansion. Given the ongoing economic challenges in Europe and other regions despite some signs of improvement in 2013, this may in part help explain the small cap performance strength.
Q: The strong performance in 2013 led to an increase in valuation. What are the potential implications of that going forward?
DK: As of the end of 2013, both large cap and small cap valuations rose meaningfully in 2013 due to strong price gains, although both remained below the peaks reached in the late 1990s and early 2000s. The price-to-earnings ratio (P/E) of the Russell 2000 based on one-year forecasted earnings per share rose from 15.0 at the end of 2012 to 19.6 at the end of 2013. While that level remains within the range of the past 10 years, it is higher than the 10-year average of about 16.2.
Although the Russell 2000’s valuation has risen above its average, small cap stocks remain an important part of a diversified portfolio. That said, earnings growth in 2014 does need to meet expectations to validate 2013’s market gains. Additionally, we believe that selective opportunities remain for active managers to add value despite the higher valuations for the asset class as a whole.
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 Banz, “The Relationship Between Market Value and Return of Common Stocks,” Journal of Financial Economics, 1981. Fama, French, “The Cross-Section of Expected Stock Returns,” Journal of Finance, 1992; Fama, French, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics, 1993.
 Fama, French, “The Cross-Section of Expected Stock Returns,” Journal of Finance, 1992; Fama, French, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics, 1993.
 Source: Compiled by Russell Product and Market Research using data from the Morningstar Direct database as of December 31, 2013.
 Source: Small cap stocks, as measured by the Russell 2000 Index and large cap stocks, as measured by the Russell 1000 Index.
 FactSet, as of March 31, 2012. Based on company’s latest reported fiscal year.