The Case For Small Cap ETFs In 2017

There seems to be a number of key trends fueling a case for small-cap investing this year. A look at how some of the more than 100 small-cap ETFs have done in recent weeks—particularly post-presidential  election day in the U.S.—does, in fact, point to significant outperformance relative to larger-cap names.

Simply put, what’s changed is the macroeconomic environment, according to Bob Doll, chief equity strategist for Nuveen Asset Management.

Doll, speaking earlier this week at Inside ETFs, argued that a move to nationalism in the U.S. and increasingly across the globe; a pickup in inflation after years of talk of disinflation; a transition from monetary easing to fiscal stimulus; and a rise in volatility should all help reshape investment goals toward more risk, more volatility and total return.

End Of Earnings Recession

Also important is the end of what was considered an earnings “recession” lasting six-consecutive quarters ending in the third quarter of 2016. Now, earnings growth—tied to an improving economy, tax and regulation reform, and pent-up demand—is a tail wind for stocks, he says.

The implication of these trends is that small-caps should outperform large-cap names because they’d offer a front-row seat to domestic earnings as opposed to the more globalized earnings tied to large-cap stocks.

Consider the performance of the largest U.S. small-cap ETF in the market, the iShares Russell 2000 ETF (IWM) versus the SPDR S&P 500 (SPY) in the past 12 months. Note the jump following the outcome of the presidential election, and the 14-percentage-point difference between the two funds: 

Investor Choices

If you are going to add a small-cap ETF to your portfolio, there are in the market today 109 funds competing in this segment, 68 of which focus exclusively on U.S. small-cap stocks—plenty of options to choose from.

Narrowing the search to the largest and most popular small0cap ETFs, there are six broadly diversified funds in this segment—ETFs that own stocks from companies with a market capitalization of about $300 million to $2 billion—with at least $1 billion in assets.

Here’s a quick look at how they differ from one another. Each tracks a different small-cap index, and in the past 12 months, has delivered different total returns:

iShares Russell 2000 ETF (IWM)

IWM is the largest small-cap ETF of them all, with an impressive $37 billion in total assets. The fund carries an expense ratio of 0.20%, and trades at penny spreads, meaning investors are shelling out about $21 per $10,000 invested to own and trade this fund.

IWM tracks the market-cap weighted Russell 2000 index, and it’s one of the most broadly diversified funds in the small-cap segment. According to our data, IWM also dips into micro-cap territory, serving up exposure than can at times be riskier than funds that stick exclusively to small-cap names.

The weighted average market cap of this portfolio—a measure of each stock’s average market cap scaled by its weight in the mix—is $2.03 billion. From a sector perspective, IWM is heavily allocated to financials, at about 20% of the fund, followed by information technology at 17% and industrials at about 15%

In all, IWM owns some 1,955 securities. The fund has outperformed SPY handily in the past one year. 

iShares Core S&P Small Cap ETF (IJR)

IJR, also from iShares, has $28 billion in total assets, and it has been growing quickly thanks in part to its much-cheaper price tag relative to IWM. IJR has an expense ratio of only 0.07%, and it trades with an average spread of 0.03%, putting its total cost of ownership at about $10 per $10,000 invested—less than half that of IWM’s.

IJR selects its securities from a different universe than IWM—it tracks the S&P Small Cap 600 Index. Owning roughly 600 stocks, IJR is considered to offer broad and comprehensive exposure to the small-cap segment for a great price despite its much smaller portfolio than IWM. Here, weighted average market cap is $1.75 billion. And IJR is known for avoiding the most illiquid small-cap names, according to our data.

IJR’s top sector exposures are to the same three sectors leading IWM’s portfolio, but with different tilts. Here, it’s industrials that lead, with an 18% allocation, followed by financials at 17% and information technology at 15%.

IJR has outperformed SPY by more than 15 percentage points in the past 12 months. The fund has also outperformed competing IWM: 

Vanguard Small-Cap Index Fund (VB)

VB, with almost $17 billion in AUM, is the market’s third-largest U.S. small-cap fund. It’s also competitively priced, with a 0.08% expense ratio. With an average spread of 0.03%, owning VB costs about $11 per $10,000 invested.

VB tracks the CRSP U.S. Small Cap Index, honing in on the bottom 2-15% of the investable universe. According to our data, this fund dabs into the midcap space—VB’s weighted average market cap is notably higher than both IJR’s and IWM’s, at $3.75 billion. If you already own a midcap ETF, there could be some overlap. The fund owns more than 1,400 securities.

VB allocates heavily to financials—almost 30% of the fund. Industrials come second, at about 18% of the portfolio.

Among the six ETFs detailed here, VB is the worst performer in the past 12 months: 

Schwab U.S. Small-Cap ETF (SCHA)

SCHA, like many Schwab ETFs, has the lowest expense ratio in the segment: 0.06%. With an average trading spread of about 0.05%, however, it costs roughly the same to own and trade as VB, or $11 per $10,000 invested. SCHA has $4.8 billion assets under management.

SCHA tracks the Dow Jones U.S. Small Cap Total Stock Market Index and owns more than 1,700 stocks. The fund’s cheap price tag, combined with broad comprehensive marketlike exposure, has boded well for a strategy that boasts strong liquidity, with more than $33 million in average daily volume.

SCHA, too, allocates mostly to financials, at about 18% of the mix, followed by industrials at 16% and information technology at 14%.

The portfolio has a weighted average market cap of $2.7 billion. SCHA was the second-weakest performer among these six ETFs in the past year: 

WisdomTree SmallCap Dividend Fund (DES)

DES is a $2 billion fund, and the most expensive among this group. The expense ratio for DES is 0.38%, with an average trading of 0.12%, meaning investors are paying about $50 per $10,000 invested to own and trade this fund.

DES is also a smart-beta approach to small-caps designed to deliver higher yield than marketlike exposure to this segment.

The fund tracks the dividend-weighted WisdomTree Small Cap Dividend Index. According to our data, DES tends to tilt toward dividend-heavy sectors like utilities at the expense of more growth-oriented segments like technology in search of that extra yield. DES, which also dips into the micro-cap names within small-caps, has a weighted average market cap of $2.06 billion. The fund has nearly 1,100 holdings.

The smart-beta approach means a different sector allocation than what we’ve seen in IWM, IJR, VB and SCHA. Here, consumer discretionary leads the portfolio’s sector weights, with a 19.5% allocation. Industrials comes second, with 19% followed by real estate, at about 14%.

DES is the uncontested best-performing small-cap ETF among these top-six funds in terms of assets. Its smart-beta approach has translated into better total returns in the past year, with a performance that exceeded that of SPY by 20 percentage points. 

Schwab Fundamental US Small Co. Index ETF (FNDA)

FNDA has $1.4 billion in assets, and it’s also a smart-beta approach to small-caps. Like competing DES, the fund comes with a more typical smart-beta price tag—a 0.32% expense ratio. That’s more than five times the cost of Schwab’s other fund, the market-cap-weighted SCHA.

FNDA trades with an average spread of 0.09%, putting its total cost of ownership at about $41 per $10,000 invested.

The strategy tracks the fundamentally selected and weighted Russell RAFI U.S. Small Company Index, picking and weighting stocks based on adjusted sales, retained operation cash flow and dividends plus buybacks.

The fundamental screens result in different sector tilts than what we’ve seen in the market-cap ETFs in this segment. It’s industrials that lead SCHA, with a 20% weighting, followed by consumer discretionary stocks at about 15.3%. Financials comes third in this portfolio.

With the highest weighted average market cap among these six ETFs, at $3.9 billion, FNDA’s portfolio of 856 stocks has slightly outperformed IWM—the biggest in the segment—in the past year. 

Charts courtesy of StockCharts.com

These six funds are only the top funds in terms of assets among broadly diversified small-cap ETFs. That means this list includes only strategies that blend value and growth names rather than focus exclusively on one or the other.

For a complete list of all small-cap ETFs in the market today, and additional analysis on these and other funds, check out our Small Cap ETF Channel.

Contact Cinthia Murphy at [email protected]