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Small cap stocks are often known as a good hunting ground for investors seeking great opportunities. There is a strong belief that it is much easier to distinguish yourself in finding opportunities among small caps relative to large caps. However, as a mutual fund or ETF grows, it is much harder to find enough small cap stocks to fill the portfolio. In fact, in looking at's universe of 7,600+ stocks, stocks with a market capitalization below $1 billion represent only 2.4% of aggregate value, despite accounting for about two thirds of the actual tickers traded. Even if you raise this threshold to $5 billion, the share of aggregate value only climbs to 11.3%.

However, building a diversified portfolio of individual small cap stocks entails a lot of transaction costs that become prohibitive for the typical retail investor. One way to avoid this is to use ETFs (or possibly mutual funds) to gain exposure to small cap stocks. This review will not be exhaustive by any measure since there are countless small capitalization ETFs and will be focused on the Vanguard products. (Note: I've been a long-time Vanguard customer). However, this type of analysis could be applied to any set of ETFs. The following ETFs were considered:

ETFs Reviewed
TickerNameAssets ($ billions)Recent PriceTTM Yield
SPYSPDR S&P 500 Trust ETF129.8160.422.1%
IJRiShares S&P Small Cap 600 Index9.790.311.4%
VBVanguard Small Cap ETF33.393.711.6%
VBKVanguard Small Cap Growth ETF11.4102.940.9%
VBRVanguard Small Cap Value ETF9.483.702.3%

Source: Yahoo!Finance

The benchmark portfolio will be SPDR S&P 500 Trust ETF (NYSEARCA:SPY). This chart also confirms that, as expected, the first analysis is to check the level of correlation between the various small cap ETFs and SPY. In comparing yields, one can see that Vanguard Small Cap ETF (NYSEARCA:VB) trails that of the broader market and correspondingly, Vanguard Small Cap Growth ETF (NYSEARCA:VBK) has a lower yield than VB and Vanguard Small Cap Value ETF (NYSEARCA:VBR) has a higher yield than VB.

TickerCorrelation 24 monthsCorrelation 36 monthsCorrelation 60 months

Source: Yahoo!Finance using split and dividend adjusted monthly closing prices and author calculations

All of these small cap ETFs have extremely high correlations to SPY. They basically move in lock step with the broader market. So if we take diversification to mean reducing portfolio volatility, the only way to capture diversification benefits is if the small cap ETFs have a lower volatility than the broader market. I suspect that this is not true.

Monthly Volatility
TickerMonthly Volatility 24 monthsMonthly Volatility 36 monthsMonthly Volatility 60 months

Source: Yahoo!Finance using split and dividend adjusted monthly closing prices and author calculations

The small cap ETFs will not improve the portfolio of a pure SPY portfolio due to their consistently higher volatilities. Perhaps in combination with a high risk portfolio they would help. However, this does not potentially address the question of the impact of international small cap ETF on portfolio volatility. Potentially there are other diversification benefits from small cap stock exposure. There is some potential for return diversification over times when small caps might be moving into or out of favor.

Small Cap ETFs have shown solid, but not amazing, returns

Total Return
Ticker2 Year Return3 Year Return5 Year Return

Source: Yahoo!Finance using split and dividend adjusted monthly closing prices and author calculations

Small caps showed a slight out performance over 2 years, a little better over 3 years and a significant lag over 5 years. So what should we read into this type of data? We actually should try to avoid drawing too many conclusions from just three time periods. As noted in this Seeking Alpha article, small caps have shown outperformance by 1-2% over longer periods of time. There is also significant research in this area.

Comparing Dividend Growth

Investors are often looking for dividends; however, small caps typically pay lower dividends than majors as noted in the first section. The following table shows the Trailing Twelve Month dividends for the Vanguard ETFs.

TTM Dividends

Source: Yahoo!Finance

The historical dividends for these ETFs do show the impact of the great recession. They also show significant variations from period to period. One should note that the Vanguard small cap ETFs pay the bulk of the annual dividend in December with a small piece in March. The other observation is that the VBK dividends have shown significant recent growth, while VBR has lagged behind more. The TTM Dividends is just the sum of the two most recent dividends. The following table shows the historical dividend growth rates.

TTM Dividend Y-on-Y Growth

Source: Author calculations


Thus one should not be purchasing small cap ETFs in hopes of reducing overall portfolio volatility. That perspective is clearly shown to be false here.

In terms of returns, it appears that small caps from this data were recently as good as the broader market despite a significant lag in the five year return. There were also variations between the growth and value small cap ETFs. So clearly there is some potential for these to shift in and out of favor.

Looking forward, small cap ETFs can potentially provide a good addition to a portfolio to help boost returns. However, research and homework are critical. It is possible that certain sectors or styles can offer upside. Small Caps are widely viewed as better opportunities to create alpha. This would be one argument against using ETFs.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.