Work in the US brokerage industry long enough and you’ll learn that June is a special month, for this is when the “Russell Rebalance” occurs. Like the old high school exam question about the Holy Roman Empire, this term is somewhat imprecise. Technically, it is the “Russell Reconstitution” since names come and go depending on market caps cutoffs. Stocks move between the Russell 1000 (large caps) and the 2000 (smaller caps), and newly public companies find their spot as well.
To the brokerage world, the nomenclature doesn’t really matter because all the toing-and-froing creates a tidal wave of trading and most of it happens on the close of the last day of the month. Christmas comes in June for Wall Street equity desks because the “Russell Rebal” is usually one of the busiest trading days of the year.
This year that date is June 28th – the same day as the hoped-for G20 meeting between Presidents Trump and Xi. Because things aren’t complex enough… And while the folks at Russell are still fine-tuning their numbers, all the recent bold-faced IPOs will certainly be in the mix. Uber, Lyft, Beyond Meat – none of these are in the Russell indices just now. But rest assured that quant hedge funds are busy gaming how much demand their inclusion will create on July 28th and figuring out the arb even as you read this note.
In doing the background work on all this, we came across a note published just last week by an MD at Russell with the title “What have you done with my small cap premium?” that is both worth a look and some further analysis. The author puts his finger on a topic we have described in prior notes, namely that US small caps seem to be in a bit of an anomalous funk of late. There’s a link to the full text at the end of this section, but here’s a quick summary:
- Over the last 40 years the Russell 2000 (small caps) have outperformed the 1000 (large caps) by 40 basis points – 11.5% compounded annual returns versus 11.1%.
- This outperformance is not, however, consistent across 10-year periods.
- Small caps beat large caps from 1979 – 1988 (16.9% vs. 16.1%) and from 1999 – 2008 (3.0% vs. -1.0%).
- But small caps underperformed large caps from 1989 – 1988 (12.9% vs. 19.0%) and from 2009 – 2018 (12.0% vs. 13.3%).
As for what’s going on here, the author points to sector concentrations and performance as a prime contributor to why small caps only outperform some of the time. For example:
- The 1000 (large caps) has a heavy historical concentration in Technology (21% at present, and 27% including GOOG, FB and AMZN).
- The 2000’s (small caps) largest sector weight is typically heaviest in Financials (15% today).
- The former has certainly worked better than the latter over the last decade, for example.
As for what all this means to small cap performance going forward, a few of our own thoughts:
#1: Keep in mind that even across a large swath of time, small cap outperformance to large caps is relatively small. That 40 basis points over 40 years is only 17% greater performance relative to returns that number in the 100s of percentage points. And there are long periods where small caps underperform, creating relative performance problems for investors who measure their timeframes by the decade or less.
#2: One thing the Russell piece ignored but we think is important is financial leverage and the cost/availability of debt capital. The period of greatest small cap outperformance (1989 – 1998) coincided with the maturation of the US high yield debt market and declining interest rates. Since smaller companies typically need access to outside capital to fund their growth, those two factors created a powerful turbocharger to equity market performance over that period.
Fast-forward to today, and the Russell 2000 clearly trades on US high yield spreads as much as corporate fundamentals/risk free rates. These have generally risen over the last year, compressing multiples. Over the last year the Russell 2000 is 8.9% lower while the Russell 1000 is 3.5% higher.
#3: Those sector weights mentioned in the Russell note are important, because to our thinking they tell a larger story about the US equity ecosystem. If the old Marc Andreessen quote about “software eating the world” is right, then smaller companies may be more susceptible to the threat of larger competitors who have the capital to build disruptive technology.
If that’s all a bit too theoretical, consider this case study:
- Neither Uber nor Lyft will likely be in the Russell 2000 small cap index when they are added at the end of this month. Their market caps ($72 billion and $17 billion, respectively) are above the $10 - $12 billion level of the largest Russell 2000 names today.
- Instead, they will likely enter the Russell 1000 large cap index.
- But… GrubHub, which is under pressure from Uber Eats, could easily drop from the Russell 1000 (it is down 38% over the last year and has a market cap of $5.9 billion) to the 2000 in the next year if it doesn’t address its competitive challenges.
- And guess where rental car company Avis Budget Group is today? Yes – in the Russell 2000.
- Even if you think Uber/Lyft are overvalued/destined for Chapter 11, they aren’t going anywhere for a few years at least. And over that time they will peck away at car rental companies and food delivery businesses. And probably other businesses dominated by smaller players…
Bottom line: there will always be good small cap companies to own, but as an asset class this one is hard to like. It will have its day – maybe even in the back half of 2019 if all the chatter about Fed rate cuts is right and financial conditions ease – but we still prefer large cap US equities.
Sources:
More information on the Russell Reconstitution, including links to tentative adds/deletes: https://www.ftserussell.com/resources/russell-reconstitution
Link to Small Cap Premium note: https://www.ftserussell.com/blogs/what-have-you-done-my-small-cap-premium