Every June, and now every December as well, one of the largest and most impactful trading events of the year takes place—with surprisingly little attention. Unlike an earnings announcement or a Federal Reserve meeting, the annual FTSE Russell reconstitution rarely makes headlines. Yet it triggers billions of dollars in trading as index funds rebalance to reflect a newly defined U.S. equity market.

For passive investors, those trades are required.

For active managers, they’re optional.

This distinction is, in our view, one of active management’s biggest structural advantages—and this year’s reconstitution offered a timely reminder of why.

Each year, FTSE Russell rebuilds the Russell 3000 by ranking eligible U.S. companies based on market capitalization. These rankings determine membership in the large-cap Russell 1000, the small-cap Russell 2000, and related indexes. The changes take effect after the final trading day in June. While the methodology is rules based and repeatable, this year’s results were anything but routine. Turnover across several Russell indexes was among the highest in recent memory, accompanied by meaningful shifts in sector composition. For example, Large Growth became even more concentrated, with semiconductor companies now representing roughly 32% of the Russell 1000 Growth Index—a level that creates practical challenges for institutional investors whose diversification guidelines often limit exposure to a single industry.

The reconstitution also quietly changed the valuation picture for small-caps. Following this year’s rebalance, the Russell 2000’s price-to-earnings multiple declined by roughly four turns, leaving the small-cap index once again trading at a meaningful discount to the Russell 1000. Our relative valuation work continues to place small-caps in the second-cheapest historical valuation quintile. We think that’s an important reminder that while investors have understandably focused on the concentration and strong performance of the largest companies, compelling opportunities continue to exist elsewhere in the market.

Small-Cap's Weight in the Russell 3000 Is Below Historical Low
Russell 2000 Total Market Cap as a Percentage of Russell 3000 Total Market Cap (%), 12/31/84-6/30/26

Source: FactSet.
Past performance is no guarantee of future results.

For us, however, the Russell reconstitution has an additional significance that highlights one of active management’s greatest structural advantages. Every year, successful companies “graduate” from the Russell 2000 because they have grown beyond the Index’s market-cap definition. For passive investors, that success creates an automatic sell order. Index funds don’t ask whether a business continues to execute successfully, whether earnings are still compounding, whether management continues to allocate capital effectively, or whether the long-term investment thesis remains intact. They simply follow the methodology.

Active managers have no such constraints.

If we believe a company continues to offer attractive long-term return potential, we can remain invested. We aren’t forced to sell simply because an index committee has reclassified its market capitalization. We’ve long believed that successful small-cap investing isn’t exclusively about owning companies while they’re small—it’s about identifying exceptional businesses early and allowing them to continue creating value as they grow.

We invest in small-cap companies because we believe that’s where many of tomorrow’s exceptional businesses get their start. We make our investment decisions based on business quality, competitive advantages, balance sheet strength, disciplined capital allocation, free cash flow generation, and long-term earnings power—not by an index’s definition of small-cap. As long as those favorable characteristics remain intact, we’re comfortable allowing successful investments to continue compounding, even after they’ve graduated beyond the Russell 2000.

Russell reconstitution serves an important purpose. It keeps indexes current and representative of the marketplace. But it also reminds us that indexes are, by design, mechanical. They classify companies by market capitalization—they don’t evaluate business quality, management teams, competitive advantages, or long-term earnings potential.

That’s where active management has one of its greatest advantages. Our job isn’t simply to own companies just because they fit an index definition. It’s to identify exceptional businesses early, remain invested as they execute, and allow them to continue creating value as they grow. In many cases, the best small-cap investments eventually stop being small-cap companies—and we view that as a sign of success, not a reason to sell.

This year’s Russell reconstitution reinforced something we’ve believed for decades: indexes are designed to classify companies. Active managers are free to invest in businesses. We believe that’s one of active management’s greatest structural advantages—and one that allows us to continue owning tomorrow’s winners long after they’ve outgrown the index where we first discovered them.

Stay tuned…

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