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New Stocks on Russell 2000 Index May Have Weaker Returns According to Drexel Finance Professor

July 1, 2008

A research paper, co-authored by Dr. Jie Cai, assistant professor of finance at Drexel University’s LeBow College of Business, and Dr. Todd Houge, CFA, assistant professor of finance at the University of Iowa’s Henry B. Tippie College of Business, finds that stock added to the Russell 2000 Index (2000 small cap stocks) may not, over the long term, perform as well as stocks deleted from the index.

“Examining additions and deletions to the Russell 2000 small-cap index from 1979 to 2004, we find that a buy-and-hold portfolio significantly outperforms the annually rebalanced index by an average of 2.22 percent over one year and by 17.29 percent over five years,” wrote Cai in the paper “The Long-Term Impact From Russell 2000 Rebalancing,” to be published in an upcoming issue of Financial Analysts Journal. “Part of these excess returns are explained by strong short-term momentum effects,” he wrote.

Conventional investing wisdom has been that when companies are added to the exclusive Russell 2000 index, their stock increases in value. Each June, the Russell 2000 rebalances (or reconstitutes) the stocks included in the index to ensure that they meet certain criteria and so that "larger stocks do not distort the performance characteristics of the true small-cap opportunity set," according to Cai.

Cai also said that “Stocks with good performance grow too big for the small-cap index, while stocks with poor performance become small enough to enter the index and continue to generate low returns. In the first year after index rebalancing, the deleted stocks outperform the added stocks by 67 basis points per month. While short-term momentum and the poor long-term returns of new issues partially explain these returns, index deletions provide significantly higher factor-adjusted returns than index additions.”

Based on the findings, Cai concludes that investors and their advisors may want to rethink how they determine long-term performance of small-cap stock funds benchmarks on the Russell 2000 index.

“To the extent that portfolio managers are evaluated based on their index-adjusted returns, this study highlights the importance of understanding how index rebalancing can also affect inferences of a fund manager’s ability," he wrote. "Fund managers who outperform their benchmark may not necessarily have exhibited skill at discovering underlying inefficiencies in the market, but rather exploited structural inefficiencies in the construction of their benchmark.” To read Cai’s and Hougue’s research in its entirety, please visit http://faculty.lebow.drexel.edu/CaiJ/Russell2000.pdf.

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News Media Contacts: Niki Gianakaris, Assistant Director, Drexel News Bureau 215-895-6741, 215-778-7752 (cell) or ngianakaris@drexel.edu Richard Barnes, Assistant Director of Communications, LeBow College of Business 215-895-2075 or richardb@drexel.edu.

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