Small-capitalization stocks have historically outperformed the S&P 500 over extended intervals and, naturally, a diversified equity portfolio including small-cap issues would have outperformed as well. For investors interested in diversifying their equity investment, small-cap stocks deserve serious attention. Once the decision is made to invest in these stocks, however, an appropriate small-cap benchmark must be found.
An analysis of the potential candidates should consider their diversification across industry sectors, capitalization levels and listing exchanges; their method of construction (especially if this biases performance); and their historical performances relative to one another and to the large-capitalization universe. In addition, the investor must take into account the transaction and administrative costs that would be involved in replicating a benchmark portfolio, data accessibility and the availability of derivative products.
A comparison of four potential benchmarks—the Ibbotson index, the Russell 2000, the Wilshire 4500 and the NASDAQ composite—suggests that the Wilshire 4500 and Russell 2000 may be most suitable. Of these two, the Wilshire 4500, because of its larger capitalization content and lower turnover, may have the advantage in terms of administrative and transaction costs.
