Could An Index Shakeup Unlock a Small Cap Rally and Spark a Russell 2000 Turnaround?

Over the long run, small caps tend to outperform large caps — but ‘long run’ might carry a different meaning from investor to investor. And in a word, the last decade (which is admittedly kinda a long time…) has been downright disappointing for smaller names.

Barring a year-long excursion in the early days of the COVID-19 pandemic, the Russell 2000 has underperformed the more attractive S&P 500, which has recently been driven by a subset of growthy Big Tech ‘Billionaire Bro’ stocks like NvidiaNVDA

, Palantir ($PLTR), and MetaMETA

.

But with the Russell Reconstitution making headlines, eyes are once again on the index — could a shakeup in the index escape its slump?

Turning a corner? Small-cap investors have needed to come up with every conceivable excuse to stay long on the languishing index, which is currently sitting on its worst year-to-date showing since 1990. But rather than waiting for ‘just one more rate cut, bro,’ Evercore ISI analysts argue that the “universally unloved small caps” could be at appealing levels now thanks to their sensitivity to tariffs, higher rates, and other macro forces. But that’s not all that’s working in its favor…

• Evercore says that “small size reliably outperforms” in June; that trend could be even bigger this year, given the weak YTD returns as investors rotate into small caps to catch the rebalance.
• The Russell 2000’s last all-time high was in November, when it appeared to be a prime candidate for a comeback, with investors taking more interest in mid-caps and analysts forecasted strong expectations for the year.

Taking a Snapshot

One of the other considerations to be had is the new composition of the index. At the end of April, the index had a majority of its membership made up of financials (19%), industrials (19%), and health care (16.7%). And with changes incoming, that could be an opportunity.

• This differs from the S&P 500, which is highly concentrated in tech-related sectors, positioning the Russell 2000 an ideal place to bet on a possible sector rotation.
• The 200+ expected additions seen spread across the Russell indexes are coming from health care, financials, and consumer discretionary — largely replacing ailing names in those industries.

Words of caution: We’ll be covering Reconstitution over the next few weeks, with a vested interest in companies making big leaps in the index. And once it’s all said and done, we’ll check back in to see how the index looks on the other side, but at a 16.8x price-to-earnings, it’s a ‘fair’ valuation compared with the S&P 500’s 24.6x. However, we’ve seen many cases (especially recently) where the Russell seemed to be turning a corner, only to get left in the dust — but a little change never hurt.