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Small-Cap Index Funds Fall Short

NEW YORK ( TheStreet ) -- With small stocks soaring in recent months, investors have poured into index exchange-traded funds and mutual funds that track the Russell 2000. During the past year, $4 billion has flowed into iShares Russell 2000 (IWM), the largest small-cap exchange-traded fund with $25 billion in assets.

But the index fund has delivered uninspiring results. During the past five years, iShares Russell 2000 returned 21.1% annually, outdoing 49% of small blend mutual funds. While the showing was not terrible, the results look disappointing when compared to the performance of S&P 500 index funds. During the past five years, SPDR S&P 500 (SPY), the largest S&P ETF, outdid 61% of large blend mutual funds. Proponents of passive investing have long argued that low-cost index funds should outdo most active mutual funds.

The weak showing of the Russell 2000 fund is not a fluke, according to research by ClearBridge Investments, which operates actively managed mutual funds. The researchers found that the Russell benchmark lagged most actively managed small-cap funds for the past 10 and 20 years.

Aram Green, a ClearBridge portfolio manager, says the index delivered poor results because of the way it is constructed. While the Russell 1000 includes the one thousand biggest stocks, the Russell 2000 benchmark covers stocks ranked by size from 1,001 through 3,000. The system automatically includes stocks that meet the size requirements, and there is no effort to exclude troubled companies.

Because many small-cap companies are shaky micro-caps with erratic sales, a big percentage of the names in the Russell 2000 are gushing red ink. In 2007, 430 of the 2,000 companies were losing money. The figure spiked to 734 in 2009 and declined to 534 in 2012. "When you own the Russell 2000 benchmark, you own a lot of companies with serious problems," says Green.

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ClearBridge found that 10% of the small-cap companies that were in the index in 2007 eventually suffered huge losses as they went bankrupt, were delisted or acquired by another company at a low price. By avoiding the troubled companies, active managers outdid the benchmark. It was much harder to top the S&P 500 because the large-cap index includes mostly successful large companies. While 27% of Russell 2000 companies were losing money in 2012, only 6% of S&P 500 companies were in the red.

To hold small-caps, consider an active fund that has consistently outdone the benchmark by focusing on solid companies. Steady performers include Hodges Small Cap.

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