The study reported here examined the long-term impact of Russell 2000 Index
rebalancing on portfolio evaluation. A buy-and-hold index portfolio outperformed
the annually rebalanced index in the 1979–2004 period by an average of
2.22 percent over one year and 17.29 percent over five years. Although
short-term momentum and the poor long-term returns of new issues partially
explain these returns, index deletions were found to provide significantly
higher factor-adjusted returns than index additions. Some small-capitalization
fund managers appear to capture a portion of these benefits. The strongest
performing funds enhanced their factor-adjusted returns by an average of 1.45
percent per year by holding index deletions and/or avoiding index additions.
Among the weakest performing funds, higher returns from holding index deletions
were offset by the poor returns of new issues added to the index. Thus, index
methodology may provide a structural incentive for portfolio managers to drift
from their benchmarks.