How we built a better US equity benchmark

If index-based investing was an innovation in 1971, it’s now part of the mainstream. The first index mutual funds were created later in the 1970s, followed by index-tracking exchange-traded funds (ETFs) in the 1990s. Index-based investment strategies have since risen to represent around half of the US mutual fund market.

According to the US Investment Company Institute, index mutual funds and index ETFs accounted for 46 percent of assets in long-term US investment funds at the end of 2022 – more than double their market share of a decade earlier.

Kelly Haughton, a Frank Russell consultant and a former Wells Fargo employee, decided that the firm’s newest client, General Motors, could do better than use the S&P 500 Index for performance measurement purposes. In Haughton’s view, the index’s choice of members (by means of a committee) rendered its approach more akin to an active strategy than to a truly objective representation of the market. Initially, Haughton looked at the Wilshire 5000 as an alternative since that index purported to represent the whole equity market. However, he found that the Wilshire 5000 included too many illiquid stocks, as well as several non-US companies with listings on US exchanges.

After consulting managers of index and active funds, Haughton found that most selected from a list of around 3000–3200 US stocks. And so the idea of a 3000-stock US equity index – which Haughton and his colleagues called the Russell 3000 Index – was born.

The index was sub-divided into a 1000-stock, large-cap index (Russell 1000 Index) and a 2000-stock, small-cap index (Russell 2000 Index).

At launch, the Russell US Indexes addressed a key need by dividing the investable US equity opportunity set into separate large-cap and small-cap segments.

By the late 1970s and early 1980s, many asset managers were highlighting the attractions of smaller companies, with some launching small-cap equity funds to capitalize on the potential client demand.

What is small cap? The Russell 2000 Index’s introduction begged a question: what is a small cap? Designers of the Russell US Indexes answered it simply. They took all US stocks, removed ineligible securities, ranked the remaining equities by their market capitalisation and selected the top 3000 stocks to make the Russell 3000 Index.

The smallest 2000 firms in the Russell 3000 became the Russell 2000, which had no overlap with the large-cap Russell 1000 Index. There’s merely a cut-off point, or ‘breakpoint’, between the two.

This process is still the way the indexes are recalculated and reconstituted each year.

The annual Russell US Indexes reconstitution day has become one of the most widely anticipated events in the US equity market calendar. In 2023, Russell recon generated aggregate trading volumes of $134 billion across US stock exchanges, making it the highest-turnover day of the year.

Russell recon is important because the size and composition of the US equity market is constantly changing. At each recon day, the Russell 3000 universe is recalculated and reset together with the constituent lists for the Russell 1000, Russell 2000 and the Russell US Style Indexes.

Originally conducted quarterly, the annual frequency of the index reconstitution balances the need for representativeness with a wish to limit unnecessary index turnover. Nevertheless, the overall index impact of Russell recon has declined over the years because of enhancements to index methodology.

Over the forty years since the creation of the Russell US Indexes, we have made other enhancements to our index methodology to ensure that indexes remain representative, objective and useful to investors. Index design changes have also reflected client feedback, the evolution of investor preferences and the ongoing changes to the US equity market’s structure.