MW The Russell 2000 is flawed - this ETF plays it in a better way for quality

By Philip van Doorn

Jason Alonzo explains the unique stock selection and weighting approach of the Harbor AlphaEdge Small Cap Earners ETF

If you research an actively managed mutual fund or exchange-traded fund that invests in small-cap stocks, it is most likely that the benchmark against which the fund management firm measures its performance is the Russell 2000 Index. But this index can be considered to be of low quality, because it includes a large number of unprofitable companies.

The Harbor AlphaEdge Small Cap Earners ETF EBIT solves this problem not only by screening the Russell 2000 for profitable companies, but by weighting its portfolio in such a way that the emphasis is on earnings, rather than a customary weighting by market value. Jason Alonzo, a portfolio manager at Harbor Capital Advisors based in New York, described the fund's indexing process during an interview with MarketWatch.

Background - the problem with the Russell 2000

The Russell 2000 Index RUT is made up of the smallest 2000 companies (by market capitalization) in the Russell 3000 Index RUA, which itself is designed to capture 98% of the market for publicly traded common stocks listed on U.S. exchanges. There are no financial performance criteria for inclusion in these Russell indexes.

In comparison, the S&P Small Cap 600 Index SML has selection criteria for a company to be added initially, including four consecutive quarters of profitability.

Now take a look at how these two indexes have performed for various periods through the close on Oct. 23:

   Index                 3-year return  5-year return  10-year return  15-year return  20-year return 
   Russell 2000                   0.9%            53%            127%            352%            411% 
   S&P Small Cap 600              6.2%            57%            151%            441%            530% 
                                                                                      Source: FactSet 

And here are average annual returns for the same periods:

   Index                 3-year avg. return  5-year avg. return  10-year avg. return  15-year avg. return  20-year avg. return 
   Russell 2000                        0.3%                8.8%                 8.6%                10.6%                 8.5% 
   S&P Small Cap 600                   2.0%                9.4%                 9.7%                11.9%                 9.6% 
                                                                                                               Source: FactSet 

The total returns include reinvested dividends.

The S&P Small Cap 600 has outperformed the Russell 2000 for all periods, but especially for the longer periods.

When asked why their actively managed small-cap funds are benchmarked to the Russell 2000, rather than the S&P Small Cap 600, fund managers will typically say that this is what their clients demand. The Russell is the most widely tracked small-cap index, and it is difficult to break that sort of habit.

It is easy to ride along most broad stock indexes with ETFs that feature low expenses. Examples include the Vanguard Russell 2000 ETF VTWO and the SPDR Portfolio S&P 600 Small Cap ETF SPSM.

The more selective approach of requiring at least four straight quarters of profits before a stock can be added to the S&P Small Cap 600 might explain its outperformance when compared with that of the Russell 2000. And it might interest you to see just how many of the Russell 2000 have been losing money.

Here are some numbers compiled using FactSet's earnings-per-share data, starting with the 1,985 stocks held by the Vanguard Russell 2000 ETF:

     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:

Focusing on profitable small-cap companies

Small-cap stocks have underperformed large-caps in the U.S. market for some time. This has made large-cap stocks more expensive on a price/earnings basis. Meanwhile, the most widely tracked large-cap index - the S&P 500 SPX - has become more concentrated at the top. It is weighted by market capitalization. This means that Apple Inc. $(AAPL)$, Nvidia Corp. $(NVDA)$ and Microsoft Corp. $(MSFT)$ together make up 20.6% of the SPDR S&P 500 ETF Trust SPY.

According to FactSet, the SPDR S&P 500 ETF Trust trades at a weighted forward price-to-earnings ratio of 21.9, based on rolling consensus 12-month estimates among analysts polled by FactSet. This is well above its10-year average forward P/E of 18.1.

The SPDR Portfolio S&P 600 Small Cap ETF SPSM trades at a forward P/E of 15.2, below its 10-year average of 18.7.

The Harbor AlphaEdge Small Cap Earners ETF EBIT trades at a forward P/E of 12, and there is no average to compare that number with, since the fund was established in July.

Jason Alonzo of Harbor explained how the new ETF pares down the Russell 2000.

The ETF tracks the Harbor AlphaEdge Small Cap Earners Index, which is reconstituted twice a year on the last trading days of January and July. The components of the Russell 2000 are screened so that companies are excluded unless they meet these criteria:

-- Median trailing 12-month operating margin (sum of operating profit divided by sum of sales)over the prior 12 quarters greater than or equal to 1%.

-- Aggregate operating margin over the prior 12 quarters greater than or equal to 1%.

The remaining companies are then weighted by relative profitability within the index over the previous three years. This means the constituents are weighted by dollars of profit. The components are subject to a 3% weighting cap when the index is rebalanced quarterly.

The index currently has 1,177 component stocks, but the Harbor AlphaEdge Small Cap Earners ETF held 696 of them as of Sept. 30. Alonzo said these stocks had been selected to track the index as closely as possible, and that he expected the holdings list to grow along with the new fund's total assets, which were only $6.6 million as of Sept. 30.

Alonzo said Harbor was "trying to solve a similar problem" to that addressed by the S&P Small Cap 600, because about 40% of companies in the Russell 2000 are unprofitable. But the S&P index is still weighted by market capitalization, and the Harbor fund's weighting by profitability makes for more of a value slant, as underscored by its lower forward P/E.

A comparison of the indexes underscores the value tilt for the Harbor ETF. The Harbor AlphaEdge Small Cap Earners Index had a weighted trailing return on equity of 13.4% as of Sept. 30, compared with 10.8% for the S&P Small Cap 600, according to Harbor's research, citing data provided by FactSet. From the same data set, the Harbor index's trailing operating margin was 21.5%, compared with a margin of 14.5% for the S&P Small Cap 600.

According to Harbor, on an equal-weighted basis, stocks of profitable companies in the Russell 2000 had outperformed those with negative operating earnings by a spread of about 10% when looking at total returns over the past 30 years through Sept. 30.

"If you want to own small cap and not rent small cap, owning the profitable segment makes a lot of sense, given the return profile we have seen," Alonzo said.

Top holdings

Here are the fund's 10 largest holdings as of that date:

   Company                                 Ticker    % of EBIT portfolio 
   Jackson Financial Inc.                  JXN                      1.8% 
   Navient Corp.                           NAVI                     1.4% 
   PBF Energy Inc.                         PBF                      0.9% 
   John Wiley & Sons Inc. Class A          WLY                      0.9% 
   Mr. Cooper Group Inc.                   COOP                     0.8% 
   New York Community Bancorp Inc.         NYCB                     0.7% 
   Sinclair, Inc. Class A                  SBGI                     0.6% 
   Peabody Energy Corp.                    BTU                      0.6% 
   Blackstone Mortgage Trust Inc. Class A  BXMT                     0.6% 
   Arbor Realty Trust Inc.                 ABR                      0.6% 
                                         Sources Harbor Capital Advisors 

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-Philip van Doorn

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October 24, 2024 10:49 ET (14:49 GMT)

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