What it means
A stock index is a basket of shares used to measure the performance of a market segment. The Russell 2000 covers small-cap companies, meaning those with a smaller total market value than the household names in the S&P 500.
Its members are drawn from the 3,000 largest US companies by market value, by taking the smallest 2,000 of them. The index is weighted by market capitalisation (share price multiplied by the number of shares available to the public), so a larger company has more influence on the index than a smaller one.
Even within the Russell 2000, the largest members have far bigger weights than the smallest. The membership is reviewed and rebalanced on a regular schedule so that it keeps reflecting the small-cap segment.
Small companies behave differently from large ones. They tend to be more sensitive to the domestic economy and to interest rates because they rely more on bank borrowing and have less diversification.
They can grow faster in good times but often fall further in downturns, so the Russell 2000 is usually more volatile than large-cap indices. For a business owner or finance professional, the index is a useful reference in several ways.
It is a benchmark for small-cap funds, a gauge of risk appetite in the economy and a point of comparison for private business valuations. When it rises sharply relative to large-cap indices, markets are often feeling optimistic about growth and credit conditions.
Investors can gain exposure through index funds and exchange-traded funds that track it. These products pay a small management fee and hold the shares in the index, so the investor gets broad small-company exposure without choosing individual stocks.
One practical point is that the Russell 2000 is a price benchmark for a wide and varied group of companies, and many of its members are thinly traded or unprofitable. Small-company funds that track it therefore tend to hold hundreds of names, and the index can move on a few large changes in membership at the annual or periodic reconstitution when companies enter and leave.
In practice
Real-world examples.
Example
A small-cap fund manager reports that her fund returned 12% in a year while the Russell 2000 returned 9%. She says the fund beat its benchmark by 3 percentage points, and she explains that the extra return came from careful stock selection rather than from taking more risk.
Example
A business owner thinking of selling his company watches the Russell 2000 for signs of investor appetite for smaller firms. A strong index suggests buyers may pay higher valuation multiples.
Example
A pension trustee allocates 10% of a $50,000,000 portfolio to a Russell 2000 index fund, meaning $5,000,000, to add exposure to small US companies.
Formula
Calculation
Weight of a company = Company's float-adjusted market capitalisation / Total float-adjusted market capitalisation of the index.
Imagine a simplified index of three companies with float-adjusted values of $2,000,000,000, $1,000,000,000 and $1,000,000,000, so the total is $4,000,000,000. The weights are $2,000,000,000 / $4,000,000,000 = 50%, $1,000,000,000 / $4,000,000,000 = 25% and 25%. If the first company rises 10% and the others are unchanged, the index rises 0.50 x 10% = 5%. The same arithmetic applies to the real index, only with the actual members and the exact weights published by the index provider.Case study
Seen in the real world.
Oakhaven Capital is an entirely fictional investment firm managing money for a family trust. The trust holds only large-company shares, and in this illustrative story the adviser proposes adding a small-cap allocation.
She presents the Russell 2000 as the benchmark and explains that it has historically been more volatile than large-company indices. The trustees agree to a 10% allocation using a low-cost index fund so that they match the benchmark rather than rely on a single manager.
In the first year the index falls 8% while large companies are flat, and the trustees worry. The adviser reminds them that the allocation was chosen for long-term diversification, and the illustrative lesson is that small caps are a higher-risk, patient-money holding. The trustees agreed to review the holding every three years rather than reacting to short-term swings.
Watch out
Common mistakes.
- Assuming the Russell 2000 contains the 2,000 largest US companies, when it holds the smallest 2,000 of the Russell 3000.
- Treating small caps as a safer holding than large caps because they are less well known, when they tend to be more volatile.
- Comparing a fund's return with the wrong benchmark, such as a large-cap index for a small-cap fund.
Questions
People also ask.
What is a small-cap company?
It is a company with a relatively small total market value, and the exact cut-off is set by the index provider and changes over time.
Who runs the Russell 2000?
FTSE Russell, which owns and maintains the index.
Can I invest in the Russell 2000 directly?
You cannot buy an index itself, but you can buy funds and exchange-traded funds that aim to track it.
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