The Russell 2000 Small-Cap index is trailing behind indices representing larger capitalization stocks, much like the Nasdaq 100 (NDX) and the S&P 500 (SPX). However, a troubling story lurks within the data.
Just as with large-cap indices, where a select few tech giants, known as the “Magnificent Seven,” hold significant sway over the index’s performance, the Russell 2000, meant for smaller businesses, faces a similar issue. In this case, it’s not the “Magnificent Seven” but rather the “Magnificent Two” outliers that have a lot of control, making this index not the best reflection of the overall small-cap market either.
Super Stars Skewing the Small Cap Show
While the Russell 2000 has lagged behind the broader market rally in 2024, its performance would be even worse if these two tech stocks—Super Micro Computer (NASDAQ:SMCI) and MicroStrategy (NASDAQ:MSTR)— hadn’t performed well. Both of these stocks had impressive growth this year, with Super Micro going up over 220% and MicroStrategy rising nearly 80% as of last week.
According to FTSE Russell, these two companies alone have contributed roughly 1.42% to the Russell 2000’s return. Without them, the index, which is currently down about 4%, would be closer to -5.5%, aligning more closely with the S&P Small Cap 600, another widely followed small-cap benchmark that has fallen roughly 6% this year.
Concentration Adds Risk
The situation defined as the high concentration of a few stocks greatly impacts an index’s performance and adds risk. As Jessica Rabe, co-founder of DataTrek Research, points out the Russell 2000 seems susceptible to similar concentration risks despite having 2,000 companies.
Rabe jokingly suggests the index might even benefit from a few “meme-ish” stocks to diversify its exposure. Another problem is that the few stocks carrying the performance of the entire index lead investors of indexed mutual funds and ETFs to commit an allocation. This leads to purchases of stocks by fund managers that are shunned by individual stock investors.
The Russell Reconstitution Coming Soon
This lopsided concentration won’t last long. The Russell 2000 undergoes an annual reconstitution, and both Super Micro and MicroStrategy are likely to be excluded due to their increased market capitalizations (currently $43 billion and $21 billion respectively).
This means the upcoming July update could significantly alter the index’s composition.
The Reconstitution Shuffle: A Window of Opportunity (or Risk)
The period between the preliminary announcement of index changes in late May and the finalization in early June creates a unique window.
When companies are added to the index, they might see a sudden increase in investor attention, which could push them out of small-cap status even before the official update. Conversely, investors holding these soon-to-be-elevated companies might face increased volatility, usually in an upward direction.
Investor Takeaway
The Russell 2000 remains a valuable and widely followed benchmark for small-cap stock performance. However, investors should note the potential distortions caused by companies that quickly show magnificence, transition out of the small-cap range, and become over-concentrated.
By considering alternative small-cap indexes and incorporating a focus on individual company fundamentals, investors can make more firmly grounded decisions within the small-cap space.
