With small- and mid-cap stocks, there’s no such thing as passive investing

These differences stem from the varied ways that two index providers, S&P Dow Jones Indices (SPDJI) and FTSE Russell, construct their widely tracked U.S. equity indexes for small- and mid-cap investing strategies; for SPDJI, we’re focusing on the S&P SmallCap 600 Index and the S&P MidCap 400 Index, and for FTSE Russell, the Russell 2000 Index and the Russell Midcap Index.

How an equity index’s profitability screening can affect valuations

One key difference is how these two providers address whether a company’s profitability should affect index construction methods.  For example, the S&P SmallCap 600 has a quality emphasis, as SPDJI requires that companies being considered for addition to that index have a record of positive quarterly earnings.¹ In contrast, the Russell 2000 lacks such a profitability requirement for index inclusion, so small companies that have yet to earn a profit can be added, provided Russell’s other criteria are met. In fact, about 41% of the Russell 2000 companies weren’t profitable as of September 30, 2023.²

Owing in part to this difference, average valuations measuring a stock’s price relative to its earnings often vary widely between the two providers’ indexes, with the Russell indexes tending to have much higher and relatively pricier valuations than their SPDJI peers at the small- and mid-cap levels. These differences are especially pronounced within growth equities, where potentially faster-growing but not-yet-profitable businesses are more likely to be found than among the ranks of the typically well-established, steadier value style segment. For example, the Russell SmallCap Growth Index’s average forward price-to-earnings ratio was recently more than double that of the S&P SmallCap 600 Growth Index. At the large-cap level, the differences were comparatively modest, as larger companies generally have long-term records of profitability.

^{_{Source: FactSet, March 2024. The S&P indexes are represented by the S&P 500 Index, the S&P MidCap 400 index, the S&P SmallCap 600 Index, and each index's value and growth variants. The Russell indexes are represented by the Russell 1000 Index, the Russell Midcap Index, the Russell 2000 Index, and each index's value and growth variants. It is not possible to invest directly in an index. The forward price-to-earnings (P/E) ratio is a stock valuation measure comparing the current share price of a stock with the underlying company’s estimated earnings per share over the next 12 months. Market capitalization is the value of a corporation determined by the market price of its issued and outstanding common stock. Past performance does not guarantee future results.}}

A deeper look at company size within small- and mid-cap indexes

Index construction also varies by company size as measured by market capitalization. At the mid-cap level, the Russell Midcap’s $11.06 billion median market cap as of February 29, 2024, was significantly larger than the $6.32 billion figure for the S&P MidCap 400. This big gap stems from the different ways that the index providers slice up the U.S. equity universe. For broad exposure across the market cap spectrum, there’s the Russell 3000 Index. Within that 3,000-stock benchmark, the Russell Midcap Index includes around 800 of the smallest securities. In contrast, The S&P MidCap 400 covers half as many stocks, so as not to overlap holdings with the S&P 500 and the S&P Small-Cap 600. Together, those two indexes and the S&P MidCap 400 make up the S&P Composite 1500 Index.

While Russell’s mid-cap offering had a higher median market cap than its S&P peer, the situation is reversed at the small-cap level; the S&P SmallCap 600’s median market cap of $1.75 billion as of February 29, 2024, was much larger than the $936 million of the Russell 2000, which has more than three times as many stocks—including tiny stocks known as micro caps—than the roughly 600 constituents in its S&P counterpart.

Choose your mid- or small-cap index carefully—it’s an active decision

Given these wide differences, an investor should understand these varied approaches and have a sense as to how they could affect potential investment outcomes. We caution against falling into the trap of thinking that passive approaches to large-cap equity investing can easily be replicated at the mid- and small-cap levels. For smaller stocks, differences in the indexes selected to track those segments require an investor to make an active choice in addition to any tactical tilts or individual security decisions that are made.

Our current mid- and small-cap preferences: bigger names, profitable companies, and industrials

When it comes to investing in small- and mid-cap stocks today, we prefer an active approach that emphasizes larger market capitalizations and more profitable businesses while tilting toward the industrials sector. This positioning reflects our view that the U.S. economy is in a late-cycle environment that should benefit higher-quality companies—those with strong balance sheets, low debt burdens, and stable earnings. We also have a favorable outlook for market segments that are trading at a discount and benefiting from themes such as increased fiscal spending and onshoring—the trend of companies focusing their operational footprints domestically rather than overseas. Our preferences draw on what we consider to be a best of both index worlds approach; we like the Russell indexes currently for their relatively higher market capitalization and industrials sector exposure, while we also see value in the S&P indexes’ higher-quality exposure. Overall, we prefer mid caps over small caps, as an emphasis on the former may reduce exposure to lower-quality stocks in general. As for small caps, we may tilt in that direction once a new economic cycle has begun. For now, we’re seeking to mitigate lower-quality and valuation risks by moving up on the market cap scale and favoring core-to-value equity style exposure.

1 This eligibility requirement doesn’t extend to existing membership in the S&P SmallCap 600, as other factors such as turnover and sector representation are considered in making index changes. 2 FactSet, February 2024.