Seeking Alpha
Contrarian, macro
Profile| Send Message|
( followers)  

Two of the highest volume ETFs available to investors are the iShares Russell 2000 ETF (NYSEARCA:IWM) and the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). These ETFs track the performance of the exchanges they are named after. Many investors use these instruments to gain exposure to stocks while achieving maximum equities diversification, and thus, lower risk to "one-time events." Of course, investing in these broad ETFs can also have the effect of muting returns compared to being invested in just a few really strong stocks, but many investors, especially ones with lower risk profiles, do opt for a diversification method this broad. Additionally, these ETFs offer the low fees and expenses relative to many mutual funds.

I thought it would be fun to evaluate the merits of investing in one index ETF over the other, going forward. While they generally move in sync, over longer periods there can be performance differences due to their make-up. For example, year-to-date performance of the IWM has been a 25.43% return. SPY meanwhile has offered a 20.12% return over the same period -- about a 5% difference over 8 months.

By their very construction, you can classify IWM companies as the "Davids" and SPY companies as the "Goliaths." That is because IWM (i.e. the Russell 2000) is composed of small-cap U.S. companies. SPY (i.e. the S&P 500), on the other hand, is basically composed of the largest 500 public companies -- though not strictly because a committee actually picks them based on a few other factors. But size of components and sheer number of components are the basic differences.

Let's look at some large factors over the next few months that may affect them based on their make-up.

Emerging Markets

Because of the size difference of the component stocks, outside factors affect them differently. One such area is exposure to overseas markets. Multi-national corporations have more exposure to foreign countries than small domestic firms by definition. Multinationals are generally larger corporations, so that means the events in foreign economies can affect these multinationals on the SPY more than the smaller domestic companies on the IWM.

The past 12-18 months have not been kind to overseas economies, including emerging markets, and that could be one reason why the SPY has underperformed since Christmas compared to the IWM.

Now it seems that emerging markets (NYSEARCA:EEM) might finally be starting a comeback after a few soft quarters, especially shown by data coming out of China (although that contains some bittersweet news too). If foreign economies speed up then exposure to these them could turn into a tailwind rather than a headwind for many SPY companies. That gives an edge to SPY companies.

Taper Effects

Taper is likely to happen this year, but it is unclear how long it will really take to fully unwind. I would argue that if it is removed quickly over a period of 8-12 months, you will see tremendous volatility.

Treasury rates are likely to rise as a result of this reduced buying of Treasuries (and eventually mortgage bonds). This will mean higher debt servicing rates and higher mortgage rates. While I do not think that those increased rates will affect the big SPY companies much differently than it will the smaller IWM ones, I do believe it will affect U.S. consumers. And because a larger portion of IWM company earnings come from the USA, I think they may be marginally worse off compared to SPY companies. That makes SPY the better choice as far as this factor is concerned.

Margin Reduction

The past few years, especially the past 12 months, we've seen earnings growth falter while stocks kept rising. This has resulted in an expanded earnings multiple for the market. Now, either revenue has to expand or margins have to expand for companies to increase earnings.

Labor data seem to hint that demand (i.e. revenue) isn't coming on line yet. That means we should look at margins.

First, note that with treasury rates likely rising because of Taper, debt servicing costs likely increase too, potentially decreasing margins as a result.

Second, margins are at an all time high. [Below is a chart showing that historical margin rate.] Simply put, the odds say that there is only so much "fat" that can be cut from a company. People make arguments all the time about why "things are different now," but we almost always find that nothing is fundamentally different. I am of the opinion that margins will not grow, but contract towards their mean when faced with debt servicing costs, Obamacare related taxes, rising energy costs, and eventual labor costs. Unless we see corporate tax rates go lower, it seems to me the pressure is downward on margins.


(Click to enlarge)

So the question then is, which index ETF will see the most margin contraction based on its components?

Even though I think both large and small will see margin contraction, I believe that because of economies of scale (the economic theory that says that the more widgets you produce, the lower the cost per "widget"), large companies will be less affected.

Also, while the whole premise of an article located here is that margins can stay high, they cite that is especially the case where corporations operate overseas. That is because overseas labor costs are frequently cheaper and overseas corporate tax rates are lower. That is something I generally agree with, although I don't think it is enough to offset domestic changes. So that tilts the scales slightly towards the SPY companies when it comes to who can hold margins up better.

Valuation

The P/E ratio TTM for the Russell is about twice as much as the S&P 500. That is normal because smaller companies often have more room to grow and are assigned higher growth expectations by the marketplace.

Compared to value stocks, smaller stocks with the higher growth expectations almost ALWAYS see the larger correction when they don't meet their growth expectations. For this reason, I think that any hiccups in the economy will result in larger losses to the IWM stocks.

Conclusion

If emerging markets are actually starting to bounce back, then that favors the SPY companies due to their larger exposure overseas. If Taper occurs and rates rise, it is likely to negatively affect the IWM companies more because they attempt to get more of their revenue from the U.S., which may be affected by higher lending rates. When margins contract, I believe it will negatively affect the IWM companies more than the SPY companies. And based on valuations, I believe that the IWM companies will underperform should the economy experience any hiccups.

So for those four reasons, while I expect the IWM and SPY to move in the same direction, I expect the IWM to underperform the SPY on a relative basis over the next 6 months.

Disclaimer: We do not know your personal financial situation, so the information contained in this article represents an opinion, and should not be construed as personalized investment advice. Past performance is no guarantee of future results. Do your own research on individual issues.

Source: Which Outperforms From Here: IWM Or SPY?