What to consider before investing in small-cap indexes

The small-cap effect is more inconsistent than many investors assume. Smaller stocks have beaten larger ones over decades, but they have oscillated between long spells of outperformance and underperformance. 

In recent years, they have seen a long streak of underperformance. That doesn’t mean that we should ignore small caps, but we should think about whether this is likely to persist and why. 

However, before getting that far, investors who want to track small-cap indexes need to consider what they are buying. We can see this most clearly in the US, where there is a choice of competing small-cap indexes.

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Look beyond the obvious in US small-cap indexes

The best-known US small-cap index – and the one with the most assets in UK-listed exchange traded funds (ETFs) – is the Russell 2000. This covers the 2,000 smallest stocks in the Russell 3000, which is FTSE Russell’s whole-of-market US benchmark. As this implies, there is a Russell 1000 index of larger stocks, which gets little attention – all the focus at the larger end of the market is on the S&P 500 index. In turn, the S&P 500 is one of three benchmarks in its own series, alongside the S&P MidCap 400 and the S&P SmallCap 600, which are often ignored in favour of the Russell 2000. 

Add all these numbers up and you can quickly see that while both the S&P 600 and Russell 2000 are viewed as small-cap proxies, they will have different market coverage. There is overlap, but some stocks will be in one and not the other. 

Still, the most critical difference between the two is something less obvious. S&P requires a stock to have been profitable for four quarters before being added to the index (although not to stay in it), while FTSE Russell has no such requirement. This acts as a very crude quality filter. Some passive purists object to this – they argue an index should simply reflect the market – but the S&P 600 has beaten the Russell 2000 by around 1%-2% per year over longer time periods (although obviously not in every individual year – the Russell did a bit better in 2023).

Appeal of UK small cap indexes

We don’t have quite the same choice for the UK, where the options are mostly limited to FTSE 250 funds. There are indexes such as the FTSE SmallCap and the FTSE Fledging, as well as the FTSE Aim series (the latter is not simply about size – some Aim stocks are FTSE 250-sized, but don’t comply with the rules for a full listing and so aren’t included in the main indexes). However, trackers aren’t available for any of these. 

There is one exception: the MSCI UK Small Cap, where iShares offers an ETF. In one way, this is less focused on small stocks than the FTSE 250, since it includes the bottom end of the FTSE 100, but there are other differences. It doesn’t include investment trusts – about 30% of the FTSE 250 – but it does include some of the larger Aim stocks. How much does this matter? For a long time, not much – but recently, a large gap has opened up. 

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