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What It Is:

The Russell 2000 index measures the performance of the 2,000 smallest companies in the Russell 3000 index. The Frank Russell Company created the index in 1984, and it was one of the first broad benchmarks of the U.S. equity market.

How It Works/Example:

The Russell 2000 is one of several subsets of the Russell 3000 index, which consists of the 3,000 largest U.S. public companies and nearly 100% of the capitalization of the U.S. stock market. The Russell 2000 index, while still very broad, composes less than 10% of the capitalization of the U.S. stock market.

The Russell 2000 follows a number of industry sectors, but excludes stocks trading below $1.00, as well as pink sheet and bulletin board stocks. The index also excludes closed-end mutual funds, limited partnerships, royalty trusts, foreign stocks, and ADRs. Because a small-cap stock can become a mid-cap stock over time, the Russell 2000 index is “reconstituted” every May. Eligible initial public offerings are added quarterly.

Unlike the Dow Jones Industrial Average, the  Russell 2000 index is weighted by shares outstanding. This means that a member stock’s last sale price as well as the number of shares that can actually be traded (rather than the company’s full market capitalization) influence the index.

Other permutations of the Russell 2000 measure the performance of companies with special characteristics. For example, the Russell 2000 Growth Index measures the performance of Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000 Value Index measures the performance of Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.

Why It Matters:

The Russell 2000 index is one of the most widely used benchmarks for small-cap stocks because it is much broader than other indices. However, it is important to note that the index excludes micro-cap and other very small stocks. Russell 2000 companies are still relatively small, however, and this makes the index volatile.

Many investors compare mutual fund performance with the Russell 2000 index because it reflects the return opportunity presented by the entire market rather than opportunities offered by narrower indices, which may contain bias or more stock-specific risk that distort a fund manager’s performance. Many mutual funds and ETFs are tied to or based on the Russell 2000.