By: Mat Lystra, senior research analyst
Carl Lewis is one of the most decorated track and field athletes in US history. At the 1984 Summer Olympics he tied Jesse Owens’s 1936 record of four gold medals. One of Lewis’s best events was the 4 x 100 meter relay where he ran the anchor leg. In a relay race, the anchor leg is the final of four 100 meter sprints and is typically run by the fastest member of the team. But should the fastest runner always go last? In track and field perhaps, but in the world of indexing a re-ordering of the line-up might just help you run a better race.
With market cap-weighted indexes, how your “team” is positioned affects the overall performance compared to a benchmark like the Russell 3000® Index. Unlike a relay race, the first leg—stocks with the largest market values and therefore the highest weights—has the most pull. One of the highest performing segments of the market for many years has been midcap. Midcap generally receives less attention than its better known large cap and small cap counterparts—sort of like Calvin Smith, who passed the baton to Carl Lewis.
Within the Russell 1000® Index, for example, midcap stocks represent roughly the last third of the index by percentage of market cap. But, because they are positioned in descending order of market cap behind larger companies like Apple and Exxon, their performance can only carry the index so far.
But what if you repositioned midcap so that instead of running the anchor leg, they were first off the blocks by being grouped with small caps? The Russell 2500™ Index does just that, including both small and mid sized companies to form a “SMID cap” segment. This allows midcaps to run the first leg of the relay and have a bigger impact on the outcome, as we’ll see moving through the table below.
Midcap stocks re-positioned atop the Russell 2500 Index
Source: FTSE Russell. Data as of May 12, 2017. Russell index constituents represent the preliminary reconstitution constituents as of rank day, May 12, 2017, which went into effect after market close on June 23, 2017. The market capitalization breakpoints for the Russell indexes are based on new additions as of 2017 reconstitution. The market capitalization ranges used above are absolute breakpoints for new members and do not include capitalization banding. Capitalization banding involves the implementation of a ±2.5% band around certain breakpoints. For further information, please refer to the Russell US Indexes construction and methodology document.
We can create a hypothetical index, using the Russell Top 200® Index (measuring large cap stocks), and the Russell 2500 Index (measuring SMID stocks), to show the potential effects of combining the two. Our hypothetical blended index is made of 70% Russell Top 200 and 30% Russell 2500 Index The table below details the performance-related characteristics of the standalone indexes, and the hypothetical blended 70:30 index.
Select volatility and performance characteristics for the Russell 2500 Index, Russell Top 200 Index and a hypothetical 70:30 blended index from December 1978 through December 2016.
Sources: MPI and FTSE Russell as of December 31, 2016. Past performance is no guarantee of future results. Returns shown prior to the index inception date and for the hypothetical blended index reflect hypothetical historical performance. Please see the end for important legal disclosures.
When added to the large caps-only Russell Top 200 Index, the SMID cap stocks in the Russell 2500 Index improved almost every performance based measure evaluated. From adding 30% SMID cap stocks from the Russell 2500 Index, the Sharpe ratio, measuring risk-adjusted index returns, improved from 0.46 to 0.49. Also noteworthy is the smoothing of up and down market capture with the 70:30 blend, improving up market capture vs. the Russell Top 200 Index and down market capture vs. the Russell 2500 Index.
The anchor leg of a 4 x 100 meter relay might best be run by the fastest sprinter, but the potential benefits of small and midcap companies teamed up within the Russell 2500 Index may provide index users with a better way to run the race.
For more detailed analysis please see the paper, The Russell 2500 Index: Running the anchor leg.
 The Russell 2500 Index is comprised of the membership of the Russell 2000 Index, and the next largest 500 stocks.
 In this context up and down market capture refers to how often an index outperforms the market when it has either a positive of negative return. We use monthly total returns in USD and the Russell 3000 Index to represent the market.
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