Banks In Drag: The Russell 2000 Exposed

In “Passive Negligence”, we highlighted how investors, on the margin, have been shifting from an active investment style to a more passive approach by favoring index and sector ETFs and mutual funds over individual holdings. We raised a concern that, in this mad dash towards the latest fad, many investors are falling prey to complacency by failing to properly analyze the underlying companies in which they are ultimately investing. 

Since Donald Trump won the election, the Russell 2000 (R2K) has been the darling of the market, increasing approximately 15%. There are many narratives that support investing in small cap stocks, as represented by the R2K, and some even have credence. That said, investors should look beyond these narratives and analyze the index’s current valuation and its underlying holdings to better judge if the R2K is a good investment.

This article was written in conjunction with J. Brett Freeze, CFA from Global Technical Analysis.

The Russell 2000

Passive investors looking to diversify their equity holdings frequently hold a number of ETFs and mutual funds that blindly follow an index or sector. Many investment professionals employ a similar approach called “closet indexing”. In other words, they own a portfolio of different equity indices and some specific sectors as a decoy to their clients. They want the appearance of providing real value by generating alpha through security selection and not simply buying the “market”. Typically such strategies, over time, provide market-like returns and little diversification. 

The R2K, in the words of Wikipedia, is “by far the most common benchmark for mutual funds that identify themselves as small cap”. Therefore, the R2K is a favorite among “closet indexers” looking to diversify their portfolios with small-cap holdings.

Like many broad-based indices, the R2K is composed of a diverse group of companies from varying industries. Currently, technology, services, healthcare and financials account for approximately 75% of the market capitalization of the index.

The following aggregate analysis of the R2K decomposes the index into nine industry classifications as well as a small catch-all category for unclassified companies. The current index constituents were held constant over the 13 year period that we reviewed. In other words, the data analyzed assumes the companies currently in the R2K, were in it for the last 13 years. This method allows for a more consistent evaluation of the index as it is currently composed. Note that 34 of the index constituents were excluded from this analysis as no data was available. The data used in this analysis is courtesy of www.gurufocus.com.

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