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The small cap asset class has performed well over the last decade and has done relatively well during this current bear market.  Typically, one would expect small cap businesses as an asset class to be affected worse than large businesses in slowing economies since they have less diversified revenue sources, are not as globally diversified, and have a harder time raising capital.  Small cap funds have been hurt this year, but not as much as the riskiness of the asset class would predict.  

However, among small cap ETFs, performance has varied widely when comparing the three ETFs that are linked to three popular small cap indexes, iShares S&P SmallCap 600 Index ETF (NYSEARCA:IJR), Vanguard Small-Cap ETF (NYSEARCA:VB) and iShares Russell 2000 Index ETF (NYSEARCA:IWM) are linked to the S&P Smallcap Index, the Russell 2000 Index, and MSCI the U.S. Small Cap 1750 Index respectively.

With only looking at some brief performance details, we can see that IJR (iShares S&P SmallCap Index) provides better return in every time period.  This is because of the index structure which is the only determinate of underlying equity holdings and not over factors like expense ratio or tracking error which are very small.  Market cap also does not seem that clear of a factor for the performance differences.  

In our research, there are differences in the index methodology that make the S&P index best suited for small cap exposure.  Simply, without going into all the detail which can be found on the index providers’ websites, the S&P indexes are governed by a committee that decides how to best capture within a given index the best representation of the defined objective.  This is far from managing, and to be included in the S&P SmallCap 600 Index, a company must be trading on the market for more than 12 months, be tested for liquidity, and have four straight profitable quarters.  The Russell and MCSI indexes are a more passive index methodology approach.  The Russell 2000 is the smallest 2000 stocks of the largest 3000 stocks traded on the stock market.  The MSCI Index is similarly the smallest 1750 stocks of the largest 2500 stocks traded in the US. 

By using these simple techniques, the S&P SmallCap Index and its investable ETF (IJR) have been able to shield investors from risks that are outside of the asset class risk like IPOs and companies that are unable to make profit, giving investors the best passive approach to capturing the small cap asset class.

Disclosure: Author holds a long position in IJR

Source: The Most Defensive Small Cap ETF