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Small cap performance sheds light on index construction methods

While blue chips continue to post gains for the fifth consecutive year, over the past few months small cap stocks have ceased to participate in the rally.  Indeed, the recent weak performance of some of the most widely used small cap indexes has been making financial news headlines. However, while small cap indexes as a whole have underperformed, the fundamentally weighted FTSE RAFI US 1500 Mid Small Index hasn’t fared as poorly as the market capitalization weighted Russell 2000.  Such differences underscore how index construction can affect performance in different market environments. 

Technical and fundamental analysts alike have offered insight on the recent small cap stocks  low performance. Technical analysts have cautioned that short-term moving average prices have dipped below long-term moving averages, potentially signaling a bear market in the near future. Fundamental analysts are pointing to overpriced stocks, with price-to-earnings multiples reaching high levels on the heels of strong 2013 performance.

Such stretched valuations are precisely what can shape performance for market capitalization weighted indexes. As a market trends upward, by design cap weighted indexes will become more heavily concentrated in highly favored stocks relative to less favored stocks. In effect, the in-favor names will occupy an increasingly disproportionate share of the index. When relative valuations reach levels such that investors feel the stock is overbought, indexes heavily weighted in these securities are particularly impacted by the ensuing sell-off.

Fundamental weighted indexes are constructed differently, and as a result have the potential to be less impacted by such market downturns.  Fundamental indexes seek to mitigate potential concentration concerns of cap weighted indexes and weight companies by their economic footprint or fundamental size. For example, the FTSE RAFI Indexes weight constituents using a composite of fundamental factors, including total cash dividends, free cash flow, total sales and book equity value. Unlike cap weighted indexes, prices and market values are not determinants of the index weights.

A closer look at the year-to-date performance of the FTSE RAFI US 1500 Mid Small Index reveals that while performance was still in negative territory, it was markedly less so than the Russell 2000.

Small Cap Index Performance

 

Source: FTSE, Russell, data as of September 30 2014.  Past performance is no guarantee of future performance.

While the Russell 2000 returned -4.4% for the year-to-date ending September 30 2014, the FTSE RAFI US 1500 Mid Small Index returned -3.0% for the same period. The Russell 2000 has also lagged the FTSE RAFI US 1500 Mid Small Index for the 3-month and 12-month trailing periods. Such data highlights that differing approaches to weighting index constituents can result in varying responses to market movements.

 

 

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