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Isn’t it sad when a beautiful theory gets utterly destroyed by an ugly fact?

That seems to be what happened to a Smartmoney magazine analysis of the performance differences between the iShares S&P SmallCap 600 ETF (IJR) and the iShares Russell 2000 ETF (IWM), which both track popular small stock indexes.

According to SmartMoney, over the past nine years the S&P 600 Index cranked out 56% in capital appreciation, compared to 23% for the Russell 2000, the standard measure of small stocks for big institutions. SmartMoney adds that since 1994, the S&P index has outperformed its Russell counterpart by two percentage points a year.

And true to form, the S&P 600 IJR is whupping the Russell 2000 IWM by a whopping margin since these ETFs’ inception in 2000, with average annual total returns of 6.2% vs. 3.9%.

Truly beautiful, and here’s the beautiful theory:

The S&P 600 Index uses screens, including a profitability screen, to gather up “some of the best companies” in the smallcap universe, while the Russell 2000 does nothing of the kind.

A little bit of digging, along with some rational faith in the stocks of fundamentally sound companies, showed this beautiful theory could be the real thing, because there’s not big overlap in the stocks these two ETFs hold.

Specifically, none of Top 10 holdings of IJR and IWM overlap according to iShares, and only two of the Top 25 overlap, according to the last available Morningstar data.

This, even though the Top 5 sectors for both ETFs are the same, albeit in slightly different order: financials, technology, industrials, consumer discretionary and healthcare.

Both ETFs fit snugly into Morningstar’s “Small Blend” style box, with average market caps of $700 to $800 million. Both show P/E ratios in the mid-20s and betas around 1.3. And both trade near the NAV of their underlying holdings. The difference in their expense ratios is negligible, .20% for IJR and .24% for IWM, all based on iShares data.

Additionally, both have paid a small distribution every quarter since their 2000 inception, with indicated yields of about 1.5%.

So the biggest difference between these two ETFs seems to be their stocks, and the S&P 600 IJR is screening for high quality businesses.

Beautiful. But here’s the ugly fact.

Beginning in the middle of 2007, Russell changed its method for annually reconstituting its index. The change in method was specifically designed to prevent traders from continuing to exploit Russell’s annual index changes with short-term arbitrage strategies.

And since that change in the middle of 2007, IWM and IJR have performed almost identically. Chart their prices at bigcharts.com and you won’t see a millimeter of daylight between them over this time period.

One lesson for investors? Forget the history archives, either of these ETFs could work for your portfolio. Investors who want to stay in step with institutions’ grand view of smallcaps might prefer IWM, while independent-minded believers in fundamental analysis might lean to IJR, but the days of a one-way no-brainer are gone.

Beautiful theories and ugly facts aside, smallcaps can be an attractive spot for a good low-cost ETF, even for investors who like to pick individual stocks. Let’s face it, individual smallcaps can be jumpier than a monkey at lunchtime while many, though not all, small-stock mutual funds stick investors with high expense ratios and hidden trading costs.

And in addition to the small stock indexes, there are ETFs for growth, value, dividend-paying and international smallcaps, as a recent Barron’s article pointed out. Of course, investors with a stomach for rollercoaster rides can find individual stocks in all these areas as well.

Some investors might ask whether the time for small stocks has passed, arguing smallcaps already made their traditional post-bottom move. I’m not artful enough a timer to weigh-in on that one, so will only say that holding smallcaps as part of a diversified portfolio has generally rewarded long-term investors.

By the way, the demolition of this beautiful theory about IJR doesn’t shake my faith about investing in the stocks of companies with strong businesses. Not in the least.

After all, when you compare ETF portfolios of 600 and 2000 stocks that have similar market caps, sector mixes, P/E ratios, dividend yields, style boxes, and on and on – it should be no surprise if you get similar performance.

And so there’s one more lesson here for investors, as well as for investment writers.

Don’t limit your homework to reviewing ancient history. The ugly fact is that things change.

For a look at a stellar ETF (VIG) that shows the value of investing in good businesses that increase their dividends, see my Seeking Alpha article, “Stocks That Raise Dividends Outperform.” For more ETF musings see “Corporate Bond ETFs: Priced for Perfect Convenience?” (LQD, JNK, CSJ).

References and Links

SmartMoney, “Mind the Gap: Similar ETFs, Different Returns,” September 28, 2009. http://www.smartmoney.com/Investing/ETFs/Mind-the-Gap-Similar-ETFs-Different-Returns/?afl=yahoo

iShares, Fund Overview, 2009. http://us.ishares.com/product_info/fund/overview/IJR.htm

Investment News, “Slim Pickings for Russell 2000 Arbitrageurs,” May 29, 2007. http://www.investmentnews.com/article/20070529/FREE/70529008

Barron’s, “Small Stocks, Big Gains,” November 28, 2009. http://online.barrons.com/article/SB125573782557591191.html

Seeking Alpha, “Stocks That Raise Dividends Outperform,” September 23, 2009. http://seekingalpha.com/article/162871-stocks-that-raise-dividends-outperform

Seeking Alpha, “Corporate Bond ETFs: Priced for Perfect Convenience?” October 7, 2009. http://seekingalpha.com/article/165244-corporate-bond-etfs-priced-for-perfect-convenience

Disclosure: Long individual stocks that may be included in these ETFs.

Source: Two Smallcap Index ETFs: Beautiful Meets Ugly