Inside Stumbling Small-Cap ETF Returns

Small-cap ETFs are struggling this year, especially those that favor the smallest firms.

U.S. large caps as represented by the SPDR S&P 500 (SPY | A-98) are up 9.3 percent for the year. Small caps reflected by the iShares Core S&P Small-Cap ETF (IJR | A-92) and the iShares Russell 2000 ETF (IWM | A-77) are down 1.3 percent and 2 percent, respectively.

I’ve included the SPDR S&P MidCap 400 ETF (MDY | A-79) for reference in the chart below too. It’s the middle ground in size, turning in a return of 5 percent so far in 2014.

Bloomberg data, total return price, 12/31/2013 to 9/22/2014

The Receding Tide Reveals the Swimwear

Here’s what’s interesting: This period of uneven performance, while brief so far, offers insight into how the broad array of ETFs in the small-cap space perform under stress.

What stands out first is the broad range of returns to date. The difference between leader and laggard in the space year-to-date is 10 percentage points. That’s the huge spread between the iShares Morningstar Small-Cap ETF (JKJ | B-85) and the PowerShares DWA SmallCap Momentum ETF (DWAS | B-43), which turned in 3.3 percent and -7.4 percent, respectively.

Size Matters

A peek at the leaders and laggards hints at performance drivers. At the top of the year-to-date performance heap are JKJ—which I mentioned above—and the Vanguard Small-Cap ETF (VB | A-100), turning in 3.3 percent and 2.9 percent returns, respectively. These two funds at the top of the small-cap returns list share a common trait: They favor larger stocks.

To back up a step, there’s little consensus on exactly what a small-cap stock is. The names of the most popular small-cap indexes—the S&P 600 and the Russell 2000—hint at the fundamental disagreement. Are there 600 small-cap stocks out there? Or are there 2000?

More important than the number of stocks in an ETF is the set of boundaries used by each ETF’s index. In other words, after ranking every stock by market cap, how far down does the ETF’s index go before a stock is considered small-cap?

While, there’s no clear answer on which small-cap definition is “right” in the long run, there’s a clear pattern in year-to-date returns: The funds that lean toward larger stocks are doing better than those that lean toward smaller stocks.

The chart below shows the year-to-date returns for six of the 23 small-cap ETFs—the two leaders (JKJ and VB); two vanilla funds (IJR and IWM); and two laggards (the WisdomTree SmallCap Earnings (EES | A-87) and the First Trust Small Cap Core AlphaDex (FYX |B-83)).

Bloomberg total return NAV, 12/31/2013 to 9/22/2014

Below, see the market-cap size distribution for each, with a clear bias toward larger stocks for the better-performing funds (JKJ and VB) and a bias toward small stocks for the laggards (EES and FYX).

ETF.com data

The point here is to understand the drivers of return. If your small-cap fund happens to be doing well in context, is it the results of its strategy or merely because it strays into midcap territory? I’d argue that the latter matters more—at least it does so far this year.

Earnings, Momentum And Risk Avoidance

While size tilts matter, size is hardly the only factor at work.

Funds with lower price-to-earnings multiples (P/Es) are faring better too so far this year, while ETFs with higher or even negative P/Es are struggling. Exhibit A: The struggling Russell 2000 funds (like IWM) have a P/E above 100, by our calculation.

Another factor—momentum—is faring poorly too. The sole momentum play in the small-cap ETF space, DWAS, is getting crushed year-to-date. DWAS tilts large and has a negative P/E—two opposing forces— but its return pattern differs so much from other funds that I believe its core strategy (momentum) is dragging it down right now.

The performance of small-caps stocks may be less about specific factors and more about a calibrated “risk-off” approach to overbought equity markets. Investors from hedge funds to moms-and-pops may be trimming their positions in riskier asset groups like small-caps—and who can blame them.

Small For The Long Haul

For most long-term investors, I’d argue that trying to identify the best small-cap definition or strategy is less important than ensuring that your small-cap fund works and plays well with others. Given that ETFs define the investment space in so many ways, the key is to avoid having unwanted gaps or overlaps in exposure. That can happen if you combine different index families for your large-, mid- and small-cap allocations. It’s fine if your small-cap fund leans small, so long as your large- and midcap funds reach down the size spectrum to cover the gap.

Conversely, you’re missing a part of the market that’s doing well now if your coverage consists of the S&P 500 for large- and midcaps and the Russell 2000 for small-caps.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.