The Russell Index Philosophy

September 01, 2006

Kelly HoughtonThere are two ways to construct an index. You can build it from the top down, working from the proverbial "Ivory Tower" to craft an index that fits a preconceived notion of how the equity markets should work. Or you can build it from the bottom up, studying investment managers to determine how the equity markets and investors actually do work.

Russell's history is steeped in the real-life world of asset management. We pioneered and continue to lead the field of global multimanager investing, putting together portfolios of managers to build and preserve wealth for all types of investors. It is no surprise, then, that our indexing philosophy follows the "bottom-up" approach: We need accurate benchmarks that can help us evaluate managers and separate skill from market performance, or we can't deliver value to clients. Real dollar performance is a cruel taskmaster.

Russell has developed its index family to reflect this need. Our philosophy is that no investment manager should be forced to pick a particular index when their investment approach differs from that index substantially.

The Russell Index Family

While we are best known for our large-cap Russell 1000 and small-cap Russell 2000 indexes, the Russell index family includes six capitalization categories:

The Russell 1000 Index covers the extensive large-cap segment of the U.S. equity universe, representing approximately 92 percent of the total U.S. market capitalization. The index includes the 1,000 largest companies in the U.S. market.

The Russell 2000 Index covers U.S. small caps, representing approximately 6 percent of the total U.S. market. It includes stocks ranked 1,001 through 3,000 by market capitalization.

The Russell 3000 Index is a broad U.S. equity index representing approximately 98 percent of the total U.S. market. It combines the Russell 1000 and Russell 2000 indexes.

The Russell 2500 Index covers the small- and mid-cap segment of the U.S. equity universe, commonly referred to as "smid" caps. It includes the smallest 2,500 securities in the Russell 3000, and is an increasingly important index for Russell (more below).

The Russell MidCap Index offers investors access to the mid-cap segment of the U.S. equity universe. It includes the smallest 800 securities in the Russell 1000 Index.

The Russell Microcap Index includes the smallest 1,000 securities in the Russell 2000 Index, plus the next 1,000 securities. It does not include less-regulated OTC bulletin board securities or so-called "pink sheet" stocks. It represents less than 3 percent of the total U.S. equity market .

Russell also offers style (growth and value) breakdowns on each of these indexes, as well as "megacap" indexes tracking the largest 50 and largest 200 companies in the U.S. Soon, we will be expanding overseas, with a complete set of international indexes that use the same rigorous methodology as our U.S. benchmarks.

Overlap-Or Listening To Managers

When we launched the Russell Microcap Index in June of 2005, we received a fair amount of criticism from the academic arm of indexing for the overlap between the small-cap Russell 2000 and the new Russell Microcap Index. Some observers believed that the indexes should be discrete, and that we were wrong to include the 1,000 smallest members of the Russell 2000 in the new Microcap benchmark.

Our reason for doing so, however, was simple: The research showed that microcap fund managers select from stocks ranked up to about the 2,000th largest security. Meanwhile, small cap managers select stocks as small as the 3,000th largest security. To start the Microcap index at the 3,000th stock-or raise the capitalization cut-off for the Russell 2000-would have meant overlooking the full opportunity set used by small cap and micro-cap portfolio managers, respectively.

Our investment manager research team has been monitoring investment managers for over 30 years, and we have observed that U.S. equity managers specialize across the cap spectrum as well as across the style spectrum. Our indexes are built to match that.

Diversifying The Small-Cap Index Market

A case in point for the importance of closely monitoring U.S. equity managers is the evolution of our small-cap family of indexes. More than a decade ago, our analysts noticed that the Russell 2000 Index did not fit all of the small-cap investment products available in the marketplace. Many managers drew on somewhat larger-cap stocks, while a new (and growing) class of managers focused almost exclusively on the smallest end of the spectrum. As a result, today Russell offers a family of small-cap indexes: the Russell 2000, Russell 2000 Growth, Russell 2000 Value, Russell 2500, Russell 2500 Growth, Russell 2500 Value and Russell Microcap indexes.

As Figure 1 shows, use of the Russell small-cap family has grown over time, thanks largely to growing use of the Russell 2500 and the style versions of the Russell 2000 and Russell 2500. In contrast, use of the regular Russell 2000 Index has remained mostly flat. This reflects the fact that different managers operate in different portions of the market, and with Russell's full slate of indexes, they are able to choose benchmarks that accurately reflect their investing universe.

Figure 1
Figure 1

Over the last few years, the mid-cap segment of the market has delivered solid returns, and the Russell Midcap and Russell 2500 indexes have performed very well. As a result, many managers have had a difficult time outperforming these indexes. Nonetheless, more and more managers are using these indexes as benchmarks, as they accurately reflect their style choices.

Conclusion

The Russell family of indexes does a good job of covering the universe of U.S. equity managers, and this is reflected in the success of the indexes in the marketplace. According to our internal research, 54 percent of institutional investor products and 52 percent of institutional investor assets are now benchmarked against Russell's family of U.S. equity indexes.1 That percentage has nearly doubled over the past four years. We hold a dominant position in style indexing as well.

As our share of the market has grown, managers have significantly diversified their use of the Russell indexes, particularly in the small-cap area. More and more managers are embracing the Russell 2500 and related style indexes, reflecting their movement into the "smid-cap" space. This more-focused benchmarking has helped clients to better understand what these managers are trying to accomplish, and has improved our ability to identify manager skill.

• Compiled by Russell Product & Marketing Research using Nelson Information's MarketPlace Web database and 1998 Survey of Performance Benchmarks. Products analyzed are primarily institutional-oriented mutual funds, separate accounts, and commingled funds. Only indexes with at least ten products benchmarked to them are included in the study.

Endnotes

1). Smith, Matthew T., and Deepak, George, "U.S. Equity Index Benchmark Usage," Russell Indexes paper, June 2006.

 

Find your next ETF

Reset All