A Cheap Way To Access Quality

The Russell 2000 is a small cap index consisting of the smallest 2,000 stocks in the Russell 3000 Index, but that’s about where any screening ends.

While Russell uses various metrics to define eligible companies, which include setting a minimum market capitalization as well as a float requirement, profitability is not a prerequisite that is built into the index. In fact, nearly half of the Russell 2000 comprises companies that are not currently profitable.

This lack of profitability has not held down the performance of ETFs that are tracking this index. The iShares Russell 2000 ETF (IWM) has gained 47.6% over the trailing year compared to a 35.1% return for the popular large cap ETF, the SPDR S&P 500 ETF Trust (SPY).

Chart courtesy of StockCharts.com

The return to easy monetary policy and the massive rebound from lows experienced last spring at the start of the pandemic is reminiscent of the phrase ”a rising tide lifts all boats.” Domestic stocks as a whole have mostly moved up without regard to fundamentals.

This means that while traditionally quality stocks that have stable earnings and strong balance sheets have traded at a premium to lower quality stocks, market movement over the past year means that is not currently the case. As the business cycle progresses and, eventually, monetary policy moves to a more normal state, quality could make a comeback.

Accessing Quality

There are factor-specific smart beta ETFs that focus on companies that meet specific quality metrics. Investors can also find actively managed ETFs that look for quality characteristics in companies selected for inclusion in their portfolio.

However, there is also a cheap way to access quality using a passive, vanilla, small cap index—find an ETF that tracks an index derived from the S&P 1500 Composite Index.

Unlike the Russell indices, the S&P 1500 indices have a profitability metric built into their index construction. For companies to be eligible to be included in the S&P Composite 1500, the sum of the most recent four consecutive quarters’ GAAP earnings must be positive, as well as the most recent quarter. The S&P Composite 1500 comprises three subindices—the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600.

There are seven ETFs that track the S&P Small Cap 600, three of which are leveraged and/or inverse options. Of the remaining four options, the SPDR Portfolio S&P 600 Small Cap ETF (SPSM) is the cheapest, ringing up at an expense ratio of just 0.05%.

Using the ETF Comparison Tool highlights the difference between the two small cap ETFs.

When it comes to cost, IWM is nearly four times as expensive as SPSM. However, since IWM has $67 billion in AUM compared to just $4 billion for SPSM, the spread is wider for the State Street product. Yet even with this wider average spread, SPSM is cheaper than IWM
 

SPSM Says Bye To Most Biotechs

The differences in the portfolio construction methodologies show up in the sector composition of the portfolios. The biggest difference between the two ETFs is the allocation to health care. Biotech companies fall under the healthcare sector and, for the most part, are not profitable. Biotech companies make up just under 10% of IWM but only makes up about 1.5% of SPSM’s portfolio.

As mentioned earlier, low quality names were boosted by a return to easy monetary policy as the Federal Reserve acted to keep markets afloat in spite of the economic turmoil wrought by COVID-19. Looking at calendar year 2020, IWM outperformed the higher quality SPSM by 8.6%.

Chart courtesy of StockCharts.com

However, this year has been a different story. Though monetary policy remains loose, with no expected rate hikes until 2023 at the earliest, quality names have performed well over the year-to-date as the bull market has entered its second year. SPSM is outperforming IWM by 7.6% so far this year.

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Chart courtesy of StockCharts.com

Whether a permanent part of your allocation or a tactical play, small caps could have potential for the near term. This asset class tends to do well during periods of economic recovery as well as during periods of higher inflation, meaning the current market environment could portend strong future returns for small cap stocks.

As the bull market matures, the fundamentals of high quality companies are likely to be recognized by the market. If so, these companies should regain their historical premium due to their strong fundamentals. Should this be the case, SPSM and other ETFs that track S&P indices could outperform their Russell competitors.

Contact Jessica Ferringer at [email protected] or follow her on Twitter