If you look into a small-cap stock mutual fund or exchange-traded fund that is actively managed, the Russell 2000 Index is probably what the fund management company uses to measure how well the fund is doing. But this index isn’t very good because it covers a lot of companies that aren’t making any money.
Not only does the Harbor AlphaEdge Small Cap Earners ETF EBIT -0.07% search the Russell 2000 for successful companies, but it also weights its portfolio so that earnings are more important than market value, which is how most portfolios are weighted. A portfolio manager at Harbor Capital Advisors in New York named Jason Alonzo talked to MarketWatch about how the fund’s indexing works. Harbor Capital Advisors has its headquarters in Chicago and is in charge of $61.3 billion in client funds.
Background: What’s wrong with the Russell 2000?
The Russell 2000 Index RUT -0.43% is made up of the smallest 2000 companies (by market capitalization) in the Russell 3000 Index
RUA -0.12% , which itself is designed to capture 98% of the market for publicly traded common stocks listed on U.S. exchanges. There are no rules about how well an investment must do financially to be included in these Russell indexes.
On the other hand, the S&P Small Cap 600 Index SML -0.59% has rules about which companies can be added, such as having made money for four quarters in a row.
Over all time periods, the S&P Small Cap 600 has done better than the Russell 2000, but it has done better over longer periods of time.
People who run actively managed small-cap funds will usually say that their clients want their funds to be benchmarked to the Russell 2000 instead of the S&P Small Cap 600 when asked why they feel that way. Many people keep an eye on the Russell as their main small-cap index, and it’s hard to break that practice.
With ETFs that have low fees, it is easy to follow most broad stock markets. Some examples are the SPDR Portfolio S&P 600 Small Cap ETF SPSM and the Vanguard Russell 2000 ETF VTWO, both of which have lost $0.37%.
The S&P Small Cap 600 may have done better than the Russell 2000 because it is more selective. A stock must have made at least four consecutive quarters of gains before it can be added to the index. Also, it might be interesting to see how many Russell 2000 stocks have been losing money.
Based on FactSet’s earnings-per-share figures, these are the numbers for the 1,985 stocks that the Vanguard Russell 2000 ETF owns:
| Negative EPS for most recent fiscal quarter | Negative EPS for sum of most recent four fiscal quarters | Negative EPS for most recent full fiscal year | |
| Number of companies | 848 | 861 | 881 |
| Percentage of companies | 42.7% | 43.4% | 44.4% |
| Source: FactSet | |||
And according to Harbor’s research, the percentage of unprofitable companies in the Russell 2000 has been increasing. Here is the firm’s 20-year chart for percentage of unprofitable companies in the index through the second quarter, using data provided by FactSet for the preceding 12 months:
