The Small-Cap Trade In July

| About: iShares Core (IJR)

Domestic small-cap stocks are a popular investment choice set in retirement plans, and many long-term investors have a strategic allocation to this asset class. After all, small-cap stocks have outperformed their large cap brethren over long-time intervals, and can enhance long-term portfolio returns for investors with a tolerance for small cap's higher risk. The graph below shows the total return of the S&P 600 Small Cap Index relative to the S&P 500 since the small capitalization index was launched in 1994. Small-cap stocks have outperformed the bellwether large-cap index by 161bps per annum over roughly the trailing twenty years.

Source: Bloomberg, Standard and Poor's

The long-run outperformance by small-cap stocks was first recorded by Rolf Banz in 1981, showing that small NYSE firms had produced significantly higher risk-adjusted returns than their larger brethren over a period between 1936 and 1977. This outperformance became memorialized for finance students by Eugene Fama and Kenneth French, who in their Fama-French Three-Factor Model added size and value factors to beta to more accurately describe stock returns. Fama, who advised on Banz's dissertation at the University of Chicago, is a director at Dimensional Fund Advisors, an investment advisor with nearly $300 billion of assets which was founded in 1981 in part to attempt to monetize the small cap premium the scholars had found.

The two most common domestic small-cap benchmarks - the Russell 2000 (NYSEARCA:IWM) and the S&P SmallCap 600 (NYSEARCA:IJR), dominate money passively allocated to domestic small-cap stocks. This article discusses why one of these indices has outperformed over the trailing twenty years. (Note: It is not the index that has an additional $12 billion of assets under management in its related ETF, signaling that there is a broad universe of investors who could benefit from reading this article.)

iShares Core S&P Small-Cap ETF, which replicates the S&P SmallCap 600 Index and has a $10.4 billion market capitalization actually has a marginally lower expense ratio (0.17%) than the iShares Russell 2000 Index (.20%) with $22.4 billion under management.

Russell 2000 Total Return Vs. S&P Smallcap 600 Total Return

Source: Bloomberg

The S&P SmallCap 600 outperformed the Russell 2000 by 175bps per annum from 1994-mid 2013. Over that time frame, a dollar invested in the S&P index would have totaled a cumulative figure forty-six percent higher than that of the Russell 2000. Part of the reason for this divergence is the difference in index mechanics between the two indices. The Russell indices are reconstituted each June with the top 1000 companies by market capitalization joining the Russell 1000, and numbers 1001-3000 joining the Russell 2000. The S&P SmallCap 600 uses less of a mechanical approach. In the S&P index, constituents must be profitable (four consecutive quarters of positive earnings), liquid (30% of shares trading annually), and have at least half of their shares publicly floated.

The July Effect

The rebalancing of the Russell indices each June leads to a market anomaly. Because the Russell index changes are rules-based and predictable, have featured large number of index changes annually (roughly one-quarter historically), and given the level of indexing to the Russell 2000 is so high, arbitrageurs are able to bid up the prices of future constituents who will have increased future sponsorship and sell/short exiting constituents before indexing participants are forced to sell these now off-index positions. In a 2005 paper by Honghui Chen of the University of Central Florida, Gregory Noronha of Arizona State University-West, and Vijay Singal of Virginia Tech entitled "Index Changes and Unexpected Losses to Investors in S&P 500 and Russell 2000 Index Funds," the authors estimate that the performance drag related to this rebalancing is between 1.30% and 1.84% annually. Comparatively, the paper estimates 0.03% to 0.12% is lost due to index changes in the S&P 500. Given the return differential between these two small cap indices has been 175bp historically, this performance drag could account for the entire return differential.

An examination of the July returns of the two indices demonstrates that the Russell 2000 has indeed lagged the returns of the S&P SmallCap 600 in July likely due to selling pressure on constituents who were deleted from the index in the preceding June. Roughly forty percent of the annual relative underperformance of the Russell 2000 has occurred in July, a result that is statistically significant. Months shaded in grey saw the S&P index outperform the Russell index.

Seeking Alpha readers should understand 1) the long-run outperformance of small-cap stocks versus large-cap stocks, and 2) the reason behind the relative outperformance of the S&P 600 Smallcap Index versus the Russell 2000 in July as the calendar turns toward that summer month.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.