By Michael Rawson, CFA
Small-cap stocks have been on fire this year, with the Russell 2000 Index of small-cap stocks returning 24.0% through July compared with 19.6% for the S&P 500 Index. Small caps make up less than 15% of the U.S. equity market, but over the long term, small-cap stocks have outperformed large-cap stocks. According to the Ibbotson SBBI 2013 Classic Yearbook, large-cap stocks have returned 9.8% between 1926 and 2012, while small caps returned 11.9%, resulting in a small-cap premium of about 1.9%. To exploit this premium, many investors choose to overweight small caps.
Among ETFs in the small-blend category, 93% of the assets are held in just four funds, iShares Russell 2000 Index (IWM), iShares Core S&P Small-Cap ETF (IJR), Vanguard Small Cap ETF (VB), and Schwab U.S. Small-Cap ETF (SCHA). These funds are fairly similar, offering diversified, market-cap-weighted exposure to small-cap stocks at low expense ratios. But each follows a different index and each has features that make them appealing to different investors.
iShares Russell 2000 Index (IWM) is by far the largest and most liquid small-cap ETF. It trades more than $3 billion in an average day, which speaks to its popularity among institutional users looking to quickly gain access to small-cap stocks. The Russell 2000 Index that this fund follows covers approximately the 2,000 smaller stocks after the largest 1,000 from the Russell 1000 Index. This results in the smallest average market cap among the four indexes and the most exposure to micro-cap stocks.
Because it is one of the oldest small-cap indexes, with broader, more transparent coverage of small caps than the S&P SmallCap 600 Index, it is frequently used as a benchmark by small-cap fund managers. While fund managers want a benchmark that is a pure, unbiased representation of the asset class they represent, they also want a benchmark that is easy to beat. Over the past 18 years, the Russell 2000 has underperformed the S&P SmallCap 600. The below chart shows that the other three indexes have had similar performance, but the Russell 2000 Index stands out as a laggard. Russell may be a victim of its own success. Because so much money is tied to it, index arbitrageurs have historically been able to front run the index changes. In response, Russell has modernized the index construction rules. It should also be noted that data for the Dow Jones US Small Cap Total Stock Market Index and the CRSP US Small Cap Index is simulated prior to 2005 and 2011, respectively. At 0.24%, IWM has the highest expense ratio in the group, however, over the past year it has actually outperformed its index thanks to securities lending revenue. Also, 0.04 basis points of the expense ratio are acquired fund fees, primarily from business development companies in the index.
iShares Core S&P Small-Cap ETF (IJR) tracks the S&P SmallCap 600 Index. Compared with the other indexes in this group, the S&P SmallCap 600 uses fewer mechanical index construction rules and includes stricter eligibility requirements for index additions. This results in lower index turnover, less than full coverage of the small-cap opportunity set, and a slight quality bias. In fact, the S&P index had only about 18% of its assets in stocks with negative retained earnings, compared with about 30% for the CRSP and Dow Jones indexes and 36% for the Russell 2000. In a sense, this is an active bet on quality as opposed to a purely passive representation of the small-cap market. While S&P has a slight bet on quality, the other three indexes have a slight tilt away from quality, which is not surprising as small caps are generally thought to be lower in quality. This is another reason why small-cap managers prefer not to use the S&P SmallCap 600 Index as a benchmark; it is less of a passive index because of these active tilts. The 0.17% point expense ratio includes 0.03 basis points of acquired fund fees. Last year, IJR won the Morningstar Award for ETFs in the Small Blend-Institutional category. Although not as liquid as IWM, IJR has ample liquidity and had better risk-adjusted returns, both factors in the awards methodology.
Vanguard Small Cap ETF (VB) has historically been the lowest-cost small-blend fund due to generous sharing of securities lending income. Last year, it won the Morningstar Award for ETFs in the Small-Blend Retail category due in part to its low cost. While not the largest small-blend ETF, VB is part of the $38 billion Vanguard Small Cap fund because all Vanguard ETFs are separate share classes of mutual funds. VB recently switched indexes to a new index provided by CRSP. Although CRSP is a new index provider, it has a long, established history of providing high-quality stock market data and research. Unlike the other indexes in this group, CRSP defines break points for its indexes based on a market-cap range rather than an arbitrary, set number of stocks. CRSP defines small caps as the 13% of the market after the stocks composing the largest 85% of the market. This results in the largest average market cap in the group and the least exposure to micro-cap stocks. Note that in the table, the average market cap data is of the indexes and not the ETFs because Vanguard provides its holdings data with a lag. Because these are all full replication indexes, the portfolio characteristics of the indexes are essentially the same as the ETFs.
While Schwab U.S. Small-Cap ETF (SCHA) has the lowest prospectus net expense ratio, it trades with the widest bid-ask spreads and it has slightly trailed its index, whereas the other ETFs in this group have typically slightly beat their indexes. Still, the fund is low-cost and bid-ask spread costs are borne by frequent traders more so than buy-and-hold investors. While most investors will be satisfied with the other ETFs in this group, Schwab waives the brokerage commissions for those trading on the Schwab platform. The Dow Jones U.S. Small Cap Total Stock Market Index covers the 1,750 stocks after the largest 750.