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Must-know: How small is small-cap?

Mike Kane of Hedgeable

Overview: How small is small-cap? (Part 1 of 3)

When Russell Indexes issued its annual fund reconstitution for 2014, it made some key changes that investors might want to think about. Of particular note is the increased market capitalization threshold between the large-cap Russell 1000 (or IWB) and small-cap Russell 2000 (IWM) benchmarks. The threshold rose to $3.1 billion – a 19% hike from 2013. Never before have $3 billion companies been categorized as small-cap, so this indicates a shift in perspective necessitated by the recent shifts in the market. Some industry leaders, like Merrill Lynch’s Steven DeSanctis, have said it’s about time we overhaul our definitions of small and mid.

Market Realist – The Russell indices use the methodology of break points between large and small-cap stocks to assign thresholds in order to adjust for the ever-changing U.S. markets (SPY) (or IVV). The previous graph shows the break points that have acted as thresholds between large and small-cap companies over the years.

According to the Russell indices, if the break point in 1984—$255 million—was still adhered to, more than 2,750 companies in the Russell 3000, or 99.8%, of the total market cap would be considered large-cap. This would leave only 243 stocks, or 0.2%, as small-caps. A lack of reconstitution could lead to issues like gaps, overlapping of coverage, alteration of risk-return characteristics of index, and distortion.

Harley Davidson (HOG), Domino’s Pizza (DPZ), and Amazon (AMZN) are all companies that started out as part of the Russell 2000 Index (IWM). Then, they shifted to the Russell 1000 Index (IWB) as their market capitalization increased.

Continue reading the next part of the series to understand the risks of changing views on small caps, according to temporary conditions.

Continue to Part 2

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