In truth, no index fund manager or investor could disagree with the statement that performance is affected by the composition of the index involved. The most common dimensions on which indices are segmented from the entire population of stocks are capitalization, growth vs. value and business composition.

In homage to Heisenberg's famous Uncertainty Principle, we cannot subdivide a population along any single dimension without affecting the distribution of all other possible dimensions. Where you draw the line on classifying a stock as, say, middle- or small-capitalization affects the resulting composition of the index along dimensions of, say, growth or exposure to the energy industry. As an aside, we should ask the question of why the investment management community feels comfortable treating capitalization differences as critical and then has no problem whatsoever, as discussed here in May, in lumping completely unrelated commodities together.

Big Differences in Small Stocks

Such has been the case with small-stock benchmarks. Let's take two benchmark indices, the Russell 2000 (RTY) and the S&P 600 (SML). The former includes the smallest 2,000 stocks within the Russell 3000 index, the latter the smallest 600 stocks within the S&P 1500 index. The names alone would suggest different average sizes, and unless the distribution of other dimensions is uniform throughout the population and perfectly uncorrelated to the dimension of size, we know we will have indices with different performances.

Let's compare the total returns of the RTY and the SML through a set of time intervals ending Friday, July 29. To investigate the commonly held belief that the SML benefits from its greater exposure to middle-capitalization issues, let's add the Russell 2500 (R2500) into the mix; these are stocks 501-3,000 in the Russell universe.

Total Returns of Selected Indices Through July
	April 30, 2005	Period December 31, 2004	July 31, 2004	Annualized May 9, 2003
S&P 600	16.72	7.93%	27.27	29.98
Russell 2000	17.72	5.05%	24.90	27.66
Russell 2500	15.60	6.58%	25.49	27.29
Source: Bloomberg, Howard Simons