Rethinking Small Cap ETFs

With the Russell 2000 down almost 5 percent this year, is there a better way to skin the small-cap cat?

For the past nine months, nervous stock market prognosticators have been sending up red flags about how you can’t have a sustained stock market rally without small-cap participation. Historically, it’s always been the case that the healthiest, most sustainable stock market rallies come from all sectors of the economy, and are often driven by smaller companies experiencing real, tangible growth.

The rally of 2013—which, if I’m being honest, felt as crazy and awesome as anything during the dot-com boom—absolutely fit the bill. Consider the relative performance of the most followed small-cap benchmark and its large-cap cousin: the Russell 2000 and the Russell 1000. Proxies for the two indexes are below in the form of the iShares Russell 2000 ETF (IWM | A-77) and the iShares Russell 1000 ETF (IWB | A-93).

Not only did small-caps participate fully in last year’s rally, they led the charge by almost 6 percentage points. So why all the jitters? The worm, as they say, turned.

Specifically, it turned in May.

After leading the charge in the rally since 2011, it looked like small caps had finally fallen out of bed, and this, it was suggested, was the beginning of the end.

And indeed, this current disconnect between large- and small-cap stocks is very real. The problem is, it’s not nearly real enough. Most investors will likely use two disparate benchmarks to compare large and small cap stocks—the S&P 500 Index for large-caps and the Russell 2000 for small-caps.

Those are imperfect comparisons: The S&P 500, like the large-cap Russell 1000 above, reaches down deep into the midcap territory, and the Russell 2000 reaches well up into midcap territory.

If in fact we spread the cap spectrum to its extremes, what we find is that the differences between the haves and have-nots in the 2014 stock market are spread almost perfectly by capitalization, from worst performing to best.

Here we’re looking at the ETFs we track with both the highest average market caps: the Vanguard MegaCap ETF (MGC | A-100), with an average cap of $145 billion; the iShares Micro-Cap ETF (IWC | B-86), with an average market cap of $470 million; and our best-fit Mid-Cap ETF, the Vanguard Mid-Cap ETF (VO | A-96), with a nearly perfect thread-the-needle average market cap of $11.6 billion.

No matter what set of ETFs or indexes you use to paint this picture, the story looks the same—virtually all of the rally we’ve seen hanging on for dear life in 2014 has been concentrated in the top few-hundred companies. Worse, it’s concentrated in just three sectors. Here’s the performance attribution for the Vanguard mega-cap ETF, MGC, so far this year.

Without the rallies we’ve seen in health care, tech stocks and a few big banks, it would be a pretty boring year. That’s in stark contrast to the performance of the smallest end of the market. Here’s 2014’s performance attribution for IWC, the iShares micro-cap stocks ETF:

The very same sector leading the charge in large-caps is just destroying returns in small- and micro-caps.

Decisions, Decisions

So what does this mean for ETF investors looking to the small-cap stocks? Well, either you’re already in a position and unhappy about it, or you’re looking for a potential ETF to play a turnaround. (If you think things are getting worse, you don’t need me to help you sell, it’s the big red “Panic” button on your keyboard.)

The thing to remember in selecting any ETF suggesting it’s providing small-cap exposure is that they’re all fudging to some extent. I had to reach down to IWC—firmly in micro-cap territory—because even the highest-rated small-cap ETFs in our universe actually contain large slugs of midcap stocks. And, as we’ve seen, even those midcaps seem to be in a different world than the true small stocks.

If you consider the major options in the ETF space, their performance so far this year is essentially perfectly aligned to how small they truly are:

The performance leader, such as it is, is the Vanguard Small Cap ETF (VB | A-100). It gets there not just by being cheap and well run—like most Vanguard funds. It’s really the current leader because it skews to the largest-cap of all 23 small-cap ETF options, with an average market cap of $3.46 billion.

The worst performer is the Guggenheim Russell 2000 Equal Weight ETF (EWRS | C-72), which, because it equal-weights, skews lowest of all the ETFs, with an average market cap of just over $1 billion, and has a 40 percent allocation to true micro-caps.

There are subtle differences in exposure along the way, but the overwhelming determinant of how these ETFs are performing is just how small they are.

As always, exposure, more than anything else, will drive your returns here. It’s just not often the nature of that exposure is as clear as it’s been in the small-cap collapse. It’s all about the cap.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.