Quality Tilt Boosts This Small Cap ETF

February 05, 2016

This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Andrew Gogerty, vice president of investment strategies at Boston-based Newfound Research LLC.

Happy New Year! For many investo­rs, this means turning the mental page when looking at an investment portfolio or returns, something Newfound relates to as the “house money effect.”

Resetting the performance clock resets our frame of reference, but going from Dec. 31 to Jan. 1 is no different than any other two-day stretch during an investing lifetime. As such, it’s important to reiterate and remind ourselves to stick to the timeless classics of investing—especially in times of uncertainty:

  • Diversify your portfolio (across holdings and investment philosophies)
  • Formulate an objective investment plan
  • Stick to it—avoid the emotional decisions
  • Know what you own … and why you own it

Admittedly, the last one is one of the less-talked-about adages, but it is the one that makes the most rudimental sense.

Small-Cap Allocation Not So Easy

Investors often fret and sweat over their large-cap exposure (growth/value, use of factors, other tilts) rather than just buying an S&P 500 Index ETF. But with fewer options in the small-cap market, allocation decisions are often more ad hoc. However, arbitrarily shoe-horning any small-cap ETF into a portfolio is not a sound philosophy.

Some of the largest, core small-cap ETFs include the iShares Russell 2000 (IWM | A-91), the iShares Core S&P Small-Cap (IJR | A-90) and the Vanguard Small-Cap (VB | A-99). But which to choose?

A cursory look at the options shows similarities across many of the operational metrics (low costs, low turnover, diversification of holdings) and all three—when traded properly using limit orders and other prudent trading rules—have ample liquidity.

Name iShares Russell 2000 iShares Core S&P Small-Cap Vanguard Small-Cap ETF
Inception Date 5/22/00 5/22/00 1/26/04
Benchmark Russell 2000 TR S&P SmallCap 600 TR CRSP US Small Cap TR
Size (in billions) 24 16 11*
Expense Ratio 0.20 0.13 0.09
Turnover Ratio % 19 14 10
# of Holdings 1,986 604 1,515

Source: Morningstar Direct
*The ETF is a share class of the mutual fund. Total assets of all mutual fund and ETF share classes are approximately $54 billion.

But it would be a mistake to make the decision a toss-up based on this cursory parity. It’s important to understand the differences in how holdings are selected and removed in the portfolio—even for a satellite allocation like small-caps.

While the size premium has been challenged lately, recent evidence published by AQR suggests that the size premium is strong as long as quality is accounted for. In other words, the magically disappeared small-cap premium may be largely due to junky, highly volatile small-caps. Therefore, just buying broad small-caps alone may not command an excess risk-adjusted return over time, but buying quality small-caps may.

Why IJR Over The Others?

So even though the iShares Core S&P Small-Cap (IJR) ETF does not have the lowest expense or turnover ratios (common decision factors), its portfolio construction process is our first choice for broad-based U.S. small-cap exposure.

One major difference between this ETF and the other two options is that IJR undergoes the typical S&P review process. This process is focused on keeping constituent turnover low, and not making holding changes on an arbitrary annual or semiannual basis.

The review process also includes an assessment of financial health and quality of a company’s earnings to qualify for inclusion and to remain in the portfolio. This focus puts a quality tilt on the portfolio that is seen in the aggregate holding statistics.

The financial metrics of the stocks in the portfolio (leverage ratio and return on assets and equity) are well ahead of the other two options:

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