I am currently reading David Swensen’s (of the Yale Portfolio fame) Unconventional Success and was very surprised to learn that he considers the Russell 2000 (a US small-cap equity index) a poorly constructed index as it suffers from very high turnover. For example, in the three years ending December 31, 2003, the index posted an average turnover of 23.4% per year.

The lesser-known S&P SmallCap 600 Index had a turnover of only 9.4% over the same period. The two indices have a very high correlation of 96%, but the trailing 10-year performance of the S&P index is superior: 11.6% versus 9.5% for the Russell 2000. Mr. Swensen suggests that the performance differential is due to “games played by arbitrageurs during the reconstitution process”.

iShares offers ETFs that track both the indices: IWM tracks the Russell 2000 and IJR tracks the S&P SmallCap 600. In my personal portfolios, I will be buying the IJR instead of the IWM to get exposure to small cap equities.