Russell 2000: Is the Small-Cap Index in a Rut?

By Linda McDonough

The Russell 2000 Index (^RUT) is feeling a bit sluggish these days.  Who can blame it?  After capping off 2014 with a 9.7% gain in the fourth quarter, the index rose another 4.3% in the first quarter of 2015.  With the onset of spring showers, the Russell wilted 2.5% in April and so far in May is up 2.0% month to date.

The Russell 2000 is an index created to capture the performance of 2,000 small cap companies.  Although the average market cap in the index is $2 billion, that number is skewed by several stocks with market caps ranging from $5 billion to $11 billion.  The more representative number is the median market cap which equals $700 million.  The median is the number at the midpoint of all the data and highlights the most common market cap for stocks in the index.  That said, the Russell is weighted by market cap, meaning that the largest cap stocks represent a bigger piece of the index and exert more influence over the index’s performance.

Small cap stocks have generally underperformed large cap stocks for the past three years.  However, last fall small caps perked up and began outperforming.  Part of this was due to portfolio managers trying to avoid earnings issues due to the stronger dollar. Small cap companies typically collect all of their revenue in U.S. dollars and are impervious to fluctuations in currencies. Large cap companies on the other hand usually sell quite a bit of goods overseas.  Their revenue is reduced when the overseas currencies fall in relation to the dollar.

Another part of the outperformance is due to the sector weightings within the index. Healthcare is the second largest sector in the Russell 2000 and has been a very robust sector. Although 8 out of the 9 sectors within the Russell were positive in the first quarter, the healthcare sector accounted for almost 40% of the first quarter gain.

In addition, two of the top ten holdings in the Russell 2000 are biotechs.  Biotech stocks have been red hot with the Nasdaq Biotech Index (NBI) up 50% in the past 12 months and up 16% this year.  However the group hit an air pocket in April, dropping 9% in the last 3 days of the month.  Isis Pharmaceuticals (ISIS) and Puma Biotech (PBYI), both top ten holdings in the Russell, dropped 11% and 23% respectively in the month of April.  Overall the healthcare sector represents about 16% of the Russell 2000 and contributed 1.6% of the first quarter gains.  Within the healthcare group biotech was responsible for about half of that performance. 

The Russell will likely regain its momentum.  Healthcare should continue to outperform the market due to increased usage from Obamacare and a favorable reimbursement environment.  Biotechs are by nature extremely volatile but have already recovered 2.5% in May. Investors should also keep their eye on the financial sector, which represents 25% of the Russell 2000, the largest industry group in the index.  The financial sector tends to outperform in periods of rising interest rates and should help propel the Russell 2000 if the Fed keeps its promise to eventually raise rates.