By Spencer Jakab
A little over two years ago, millions of investors found themselves owning a stake in Enochian Biosciences, a money-losing drug development company few had heard of.
Even fewer would have bought it on purpose. The man listed as its "scientific founder" and largest shareholder had just been arrested for murder. It turned out that he wasn't a doctor as claimed, or even a college graduate, and that he was wanted for selling bogus cures in his native Turkey. Despite much of that being public information already, a large number of the company's shares were bought automatically by funds that track the Russell 2000 index, the most closely followed gauge of America's small companies.
Several weeks earlier, on what is called "Rank Day" in the small-cap stock-investing world, Enochian had gained entry by being worth at least $240.1 million -- that year's cutoff. Its stock had doubled in the previous year to $7 a share. On the day that index funds were forced to buy it while simultaneously selling companies booted from the benchmark, they still paid as much as $3.70 a share. Over the ensuing 12 months, the stock lost another 85% and then saw another flurry -- this time, of forced selling -- locking in a loss.
Investors who embrace passive investing pay too little attention to how stock indexes are built. Companies gaming the system, or just being of low quality, create an imperceptible drag that has cost investors hundreds of percentage points of gains over the years.
Close to $11 trillion of investor money follows various Russell indexes, and its leading ones are based on market value alone, slicing the market into about 1,000 large-capitalization stocks, 2,000 small-capitalization ones and microcaps below that.
"The goal of the index is to be representative" says Catherine Yoshimoto, director of Product Management at FTSE Russell.
Other indexes have personalities, for better and worse. The granddaddy of them all, the Dow Jones Industrial Average, reflects the opinions of its gatekeepers, who include editors of The Wall Street Journal. While the 30-member gauge certainly wouldn't see a company mired in controversy added to its ranks, changes aren't always well timed.
When aluminum company Alcoa saw its long Dow tenure end in 2013 for no longer being representative of the U.S. economy, it delivered a return 10 times that of the index over the following year. And the index's overseers booted Exxon Mobil four years ago yet kept Chevron as a representative of the oil industry. Exxon has trounced its smaller rival with a total return more than twice as high.
Few funds follow the clunky Dow, but the S&P 500, managed by S&P Dow Jones Indices, is the most-tracked stock benchmark in the world. By focusing on factors such as profitability and how easy a company's shares are to buy, a company committee has in the past excluded stocks that would have been worth owning.
Warren Buffett's Berkshire Hathaway famously didn't get in until 2010 when it split its "B" shares. By then, it was the most valuable American company not in the index. Between 1965, when Buffett took over, and 2010, it grew its book value by 490,000% or about 78 times the performance of the S&P 500.
Tougher standards were costly both before and after previously unprofitable Tesla was finally added in December 2020 as the largest company to ever enter the index. Once it looks like the committee will relent, passive investors can wind up paying an inflated price. The EV maker's stock rallied by almost 800% in the year before it got included but has been stuck in neutral since, lagging behind the S&P 500 by 58 percentage points. Getting Tesla wrong has a lot more impact on fund investors than a tiny company at the margins like Enochian.
Small duds add up, though, and, in the meme stock era, some questionable ones aren't so small. Consider Trump Media & Technology Group. It reported sharp losses in its most recent quarterly results on revenue that would be low for a single McDonald's restaurant, yet retail excitement among the former president's fans propelled it to a value of about $4.5 billion when it entered the large capitalization Russell 1000 a month ago. That is unlikely to last. Fortunately, its index weight is limited due to low float -- the number of shares that actually can be traded.
The gyrations can be crazier internationally. Chinese company Ding Yi Feng Holdings, listed in Hong Kong, became one of the world's top-performing stocks, mysteriously soaring more than 8,000% to gain a spot in index provider MSCI's All-Country World Index in 2018 and 2019. Individual investors in Vanguard and BlackRock funds became some of its largest shareholders despite there not being much of a business behind it. MSCI reversed course and removed it after its shares were suspended, but too late to avoid a painful loss for fund investors.
During a recent surge of investor interest in neglected small U.S. companies, Russell's index got almost all of the ink. Since July 10 it has trounced the previously red-hot Nasdaq 100 by more than 17 percentage points. Pretty much anything with "small cap" on the label has worked for that tactical trade.
But investors in the category for the long haul should consider how companies get into their fund. The less-followed S&P 600 small-capitalization index -- dating to 1994, making it seven years younger than the Russell 2000 -- has only about $137 billion tracking it. By screening for profitability, though, it has beaten its more popular competitor by more than 700 percentage points since then.
Index funds -- and beaten-down small-caps specifically -- might well be the cure for recently sagging portfolios. Just read the label carefully.
Write to Spencer Jakab at Spencer.Jakab@wsj.com
(END) Dow Jones Newswires
July 26, 2024 05:30 ET (09:30 GMT)
Copyright (c) 2024 Dow Jones & Company, Inc.
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