As index funds play a larger role in the core lineup of defined contribution (DC) plans, plan sponsors have a greater responsibility to ensure that the benchmarks selected for each fund are complementary — and that they don’t introduce unintended gaps or overlaps in market coverage that could lead to meaningful differences in performance and participant outcomes.
An example of how two seemingly similar equity indices can yield different results is found in the comparison of the Russell 2500 Index and the Russell Small Cap Completeness (RSCC) Index. This year alone, the difference in performance was over 10% year-to-date as of September 30, 2020.
In this article, we review the trends toward indexing in DC plans, summarize construction methodologies for the Russell 2500 and RSCC indices and explore why the latter is a more effective complement to the S&P 500 Index in a plan lineup.
With a focus on fees and simplicity, plan sponsors have continued to introduce index funds to plan lineups, with the percentage of plans offering index funds increasing from 79% in 2006 to 91% in 2016 . A recent annual DC survey from a major consultant also reported that the vast majority of plans (92%) offer a mix of active and passive funds, with 18% showing an increase in the proportion of passive funds in 2019 (compared to 5% increasing the proportion of active funds).
While there are a number of benefits to increasing the number of index options in DC plans, this increase also may expose participants to potential unintended risks if the index core lineup is not constructed in a thoughtful manner. Differences in US Small/Mid Cap Index constructions, and the resulting performance differences, highlight the cost to participants of these unintended risks.
Within our DC book of business, we find that plan sponsors frequently opt to offer distinct US Large and US Small/Mid Cap Index funds in their DC core lineup. For US Large Cap, the S&P 500 is the benchmark of choice with over $4.6 trillion in assets indexed to it. With regards to US Small/Mid Cap, providers seem split on the preferred benchmark. We lead with a fund benchmarked to the RSCC Index whereas some large providers utilize the Russell 2500 Index. Does it matter?
Historically, the RSCC and the Russell 2500 benchmarks have delivered comparable results; however, in 2020 this differential widened considerably (Figure 1), highlighting how even subtle differences in index construction can lead to a divergence in performance.
Figure 1: Annual Index Returns
To better understand what’s driving the difference in relative index performance, we need to assess the differences between each index methodology and determine their compatibility with the S&P 500.
RSCC Index: “The Russell Small Cap Completeness® Index measures the performance of the Russell 3000® Index companies excluding S&P 500 constituents. The Russell Small Cap Completeness® Index is constructed to provide a comprehensive and unbiased barometer of the extended broad market beyond the S&P 500 exposure.”
Russell 2500 Index: “The Russell 2500™ Index measures the performance of the small to midcap segment of the US equity universe, commonly referred to as “smid” cap. The Russell 2500™ Index is a subset of the Russell 3000® Index. It includes approximately 2500 of the smallest securities based on a combination of their market cap and current index membership.”
Unlike the Russell 2500, the RSCC Index is explicitly designed to complement the S&P 500 Index and capture all stocks outside of the S&P 500 Index in the Russell 3000 Index. The Russell 2500 Index methodology, however, does not take the holdings of the S&P 500 Index into consideration in its index methodology, resulting in a coverage gap. Several strong-performing, well-known stocks such as Tesla, Zoom and Square fell into this gap in 2020. In total, 65 stocks representing a combined market cap of $1.35 trillion were part of the RSCC Index but were not included in the Russell 2500 Index and therefore missing in DC plans that offer index options benchmarked to the S&P 500 Index and Russell 2500 Index. Figure 2 highlights the 10 largest stock positions in the RSCC Index that are not included in the Russell 2500 as well as their performance impact. This unintended coverage gap negatively affected participants who were offered and invested in both a Russell 2500 Index and an S&P 500 Index strategy.
Figure 2: Largest 10 Stocks by Market Cap Not Represented
in the Combined S&P 500 Index and Russell 2500 Index
Call to Action
Index selection is of critical importance when constructing an index lineup within your DC plan. When offering index funds tracking the S&P 500 Index and Russell 2500 Index, consider switching to indices specifically designed to complement one another.
We’ve been building and managing some of the world’s most successful index funds for over 40 years. Our goal? To deliver clear, reliable returns with no surprises or unintended biases, in the most cost-effective way possible.
Please email us at SSGADefinedContribution@ssga.com if you’d like to explore our US Small/Mid Cap Equity Index options or to evaluate your index fund lineup for unintended biases.
|Fund Name||Index||Total Expense Ratio (TER)||Investment Minimum|
|State Street Russell Small Cap® Index Securities Lending Series Fund Class II||Russell Small Cap Completeness Index||2.0 bps||$10 Million|
1 The BrightScope/ICI Defined Contribution Plan Profile: A Close Look at 401(k) Plans, 2016
2 Callan 2020 DC Trends Survey
The views expressed in this material are the views of SSGA Defined Contribution as of November 1, 2020, and are subject to change based on market and other conditions.
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Exp: November 30, 2021