Buckle Up For This Small Cap ETF Ride

U.S. small-cap ETFs have been staging a good run in recent weeks, but that performance has been experienced differently depending on the fund.

One case in point is the performance of equal-weighted small-cap ETFs versus traditional market-cap funds.

As a flavor of smart beta, equal weighting is often associated with a portfolio tilt toward smaller, more value names within an equity segment. These ETFs may diverge from the plain-vanilla take on the market, but they can deliver both outperformance and underperformance in any given period of time.

Consider one of the most recent launches in the small-cap segment, the equal-weighted IQ Chaikin U.S. Small Cap ETF (CSML).

Having come to market in May 2017, this IndexIQ fund tracks an index based on Chaikin Analytics’ Power Gauge, relying on a quantitative model based on some 20 fundamental and technical metrics used to pick stocks. The fund then equal-weights them in a portfolio that comprises just over 230 names.

Underperforming & Outperforming

Investors have been embracing this strategy. Coming to market with some $30 million in assets right out of the gate, and amassing nearly $65 million in assets in less than a month, CSML has already gathered some $196 million in net inflows since its inception mid-May. The asset gathering pace is among the strongest for any new launch this year.

But how does the fund’s performance stack up against the segment’s heavyweights—funds like the $41 billion iShares Russell 2000 ETF (IWM)?

In the 4 ½ months since it came to market, CSML has already both underperformed and outperformed IWM, which tracks a market-cap-weighted index of U.S. small-cap stocks ranked 1,001 to 3,000 by market cap. IWM has gathered some $1.26 billion in fresh net assets during that time.

Attribution analysis done by several different groupings—including economic sector, size, valuation, beta and dividend yield—all failed to show any “clear pattern” that explains CSML’s relative performance to that of IWM, according to FactSet ETF analyst Scott Burley.

Since it came to market in mid-May, CSML has lagged IWM’s returns by nearly 1.5 percentage points. The fund has also lagged the performance of the SPDR S&P 500 ETF Trust (SPY), even though IWM is slightly outpacing SPY. 

But in the past 30 days, equal weighting has worked really well, with CSML outrunning IWM and SPY, as the chart below shows: 

Charts courtesy of StockCharts.com

Heavy Concentration

“One thing that stands out is that CSML has a more much concentrated portfolio than IWM,” Burley said—232 holdings versus 1,993, respectively.

Looking at Herfindahl-Hirschman indices—a widely used measure of market concentration by analysts—CSML is almost five times more concentrated than IWM, Burley noted. CSML sits at 0.0045, while IWM is at 0.0010, as of Sept. 22.

“Equal weighting mitigates the concentration effect, but only to a point,” he said. “Because CSML is more concentrated, the underperformance that it’s seen so far could simply be explained by a handful of bad picks or omissions.”

“That doesn’t mean this is just noise—there could be some obscure feature of the fund’s strategy that caused it to underperform here—but I’d expect this fund to be volatile relative to its larger peers,” he added.

Fasten Your Seatbelt 

That’s crucial. The smart-beta newcomer has come to innovate in the small-cap space, but it has also shown that smart-beta ETFs don’t always translate into outsized gains relative to the market. Smart beta can, however, mean a more volatile ride—at least in this case.

CSML’s underperformance since inception has already given way to outperformance in the past month alone. You could argue that the lag in July-August was a “temporary episode,” as Burley put it.

In the end, CSML’s multifactor take on the single factor of size, and the equal weighting of the portfolio, is a flavor of smart beta that doesn’t promise consistent outperformance—a common misconstruction of what the term “smart beta” means.

CSML carries an expense ratio of 0.35%; IWM’s is 0.20%.

Contact Cinthia Murphy at [email protected]