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Vanguard Total-Market Fund's a Better Choice

While the Russell 2000 benchmark is widely used, it has not been the best-performing choice. During the past 10 years, iShares Russell 2000 returned 9.9% annually, compared to a 11.1% for iShares Core S&P Small-Cap (IJR), which tracks the S&P small-cap 600 benchmark. Part of the return gap can be traced to how the benchmarks are designed.

The Russell system is purely mechanical. The 1,000 biggest stocks go into the Russell 1000. Stocks that rank from 1001 to 3000 in size go into the Russell 2000. The S&P 600 portfolio is selected by a committee that seeks to provide a representative cross section of stocks. To make the list, a company must report positive earnings for the past four quarters.

While the Russell 2000 can include shaky start-ups that have never recorded earnings, the S&P benchmark only takes profitable IPOs that have traded for at least six months. "A lot of the Russell companies are unprofitable," says Michael Rawson of Morningstar. "The S&P 600 tilts a little bit to quality companies."

The higher-quality S&P benchmark has fared better in downturns. During the turmoil of 2008, iShares Russell 2000 lagged iShares Core S&P Small-Cap by almost 3 percentage points.

Rawson concedes that iShares Russell 2000 can be a sound choice for institutions because the ETF has enormous daily trading volume of $1.5 billion worth of shares. With so many shares changing hands, an institution that wants to sell $1 million worth of the ETF would likely have little trouble finding a buyer who would offer an acceptable price.

Trading could be more difficult for a pension that wants to sell a big amount of iShares Core S&P, which trades about $30 million daily.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.
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