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Small capitalization stocks are often seen as providing two major benefits: Diversification and greater returns. This article will focus on small capitalization ETFs from around the world to see if they do provide these benefits. This review will not be exhaustive by any measure since there are countless small capitalization ETFs, let alone the additional funds and individual securities that a casual investor can access. However, the goal was to provide a good mix of options from the U.S. to developed markets to emerging markets, as well as a cross section of investing styles from value to growth to sector focused.

The following ETFs were considered:

ETFs Reviewed


Ticker Name Assets ($ millions) Yield Geography Focus
SPY SPDR S&P 500 Trust ETF 95,300 1.7% U.S. Large Cap Index
IJR iShares S&P SmallCap 600 Index 7,450 1.0% U.S. Small Cap Index
PDN PowerShares FTSE RAFI Dev Markets ex-US Small/Mid 120 1.8% ex - U.S. Developed Small Cap
LATM Market Vectors LatAm Small-Cap Index ETF 27 NA Latin America Small Cap
ILF iShares S&P Latin America 40 Index 2,660 2.3% Latin America Large Cap Index
BRF Market Vectors Brazil Small-Cap ETF 932 1.4% Brazil Smalll Cap
EWZ iShares MSCI Brazil Index Fund 12,690 3.8% Brazil Large Cap
VBK Vanguard Small Cap Growth ETF 8,870 0.4% U.S. Growth
VBR Vanguard Small Cap Value ETF 7,570 1.9% U.S. Value
XLU Utilities Select Sector SPDR 3,690 4.0% U.S. Large Cap Utilities
PSCU PowerShares S&P SmallCap Utility ETF 46 0.0% U.S. Small Cap Utilities
EWX SPDR S&P Emerging Markets Small 655 0.5% Emerging Small Cap
EEM iShares MSCI Emerging Markets Index 36,650 1.4% Emerging Large Cap

Source: Yahoo Finance downloaded on March 29, 2011.

Some additional larger capitalization ETFs from different sectors and geographies were also included to provide a comparison with respect to the diversification benefits. The benchmark portfolio will be SPDR S&P 500 Trust ETF (NYSEARCA:SPY). The first analysis was to check correlations to see if small cap ETFs indeed offered lower correlations than corresponding large capitalization ETFs.

ETF Correlations to SPY


Ticker 11 Month Correlation 30 Month Correlation 60 Month Correlation
SPY 100.0% 100.0% 100.0%
IJR 95.3% 93.6% 92.3%
PDN 93.6% 93.2% NA
LATM 64.8% NA NA
ILF 87.1% 87.2% 82.0%
BRF 57.5% NA NA
EWZ 85.6% 82.7% 76.1%
VBK 96.1% 94.7% 93.6%
VBR 97.8% 96.1% 93.6%
PSCU 90.9% NA NA
XLU 76.0% 72.0% 67.7%
EWX 70.9% 84.7% NA
EEM 86.6% 90.1% 86.6%

Source: Yahoo Finance downloaded on March 29, 2011 using split and dividend adjusted monthly closing prices.

The first observation is that the smaller cap ETFs seem to offer lower correlations than the larger cap ETFs. For example, EWX had a correlation that was around 15% points lower than EEM, which has more large capitalization stocks. However, it was also interesting to note that the U.S. focused ETFs have very high correlations to SPY. The first column was set at 11 months simply because that was the longest time frame over which there was data for all tickers.

I would not place much, if any, emphasis on the magnitude of the difference, but rather note that in almost all cases the smaller cap variation showed a lower correlation to SPY. However, does this help with portfolio diversification? While the correlation might be lower, if the volatility is substantially higher than the overall portfolio, volatility might increase. The next table looks at volatilities over the same time frames.

Monthly Volatility


Ticker Volatility over 11 Months Volatility over 30 Months Volatility over 60 Months
SPY 4.6% 6.3% 5.1%
IJR 5.8% 8.1% 6.3%
PDN 5.6% 8.2% NA
LATM 5.1% NA NA
ILF 5.8% 9.8% 8.7%
BRF 6.1% NA NA
EWZ 6.7% 10.7% 10.2%
VBK 6.2% 8.2% 6.7%
VBR 5.8% 8.6% 6.7%
PSCU 2.9% NA NA
XLU 2.7% 4.6% 4.4%
EWX 5.2% 9.9% NA
EEM 5.7% 9.3% 8.1%

Source: Yahoo Finance downloaded on March 29, 2011 using split and dividend adjusted monthly closing prices.

So, in all likelihood, the small cap ETFs will not improve the portfolio of a pure SPY portfolio due to their consistently higher volatilities. The following table shows this impact using the 30 month data set.

Impact on Portfolio Volatility


Ticker Correlation Volatility 50% SPY/ 50% Ticker Volatility Volatility Impact
SPY 100.0% 6.3% 6.3% 0.0%
IJR 93.6% 8.1% 7.1% 0.8%
PDN 93.2% 8.2% 7.1% 0.8%
ILF 87.2% 9.8% 7.8% 1.5%
EWZ 82.7% 10.7% 8.2% 1.9%
VBK 94.7% 8.2% 7.2% 0.9%
VBR 96.1% 8.6% 7.4% 1.1%
XLU 72.0% 4.6% 5.1% -1.2%
EWX 84.7% 9.9% 7.8% 1.5%
EEM 90.1% 9.3% 7.6% 1.3%

Source: Yahoo Finance downloaded on March 29, 2011 using split and dividend adjusted monthly closing prices.

So portfolio volatility is not really improved with the addition of these ETFs. The exception was XLU, which reduced volatility due to its low inherent volatility. The final check is to look quickly at historical returns with the hope that the smaller capitalization ETFs have shown stronger returns to compensate for the higher volatility.

The table below shows returns.

Recent Returns


Ticker 11 Month Return 30 Month Return 60 Month Return
SPY 13.2% 19.6% 11.5%
IJR 15.9% 24.9% 15.1%
PDN 13.7% 50.4% NA
LATM 20.9% NA NA
ILF 11.1% 43.2% 106.6%
BRF 21.9% NA NA
EWZ 7.5% 51.1% 116.2%
VBK 23.0% 42.8% 29.0%
VBR 11.6% 22.3% 12.3%
PSCU 11.1% NA NA
XLU 8.3% 5.0% 21.0%
EWX 6.5% 62.7% NA
EEM 12.9% 43.2% 52.3%

Source: Yahoo Finance downloaded on March 29, 2011 using split and dividend adjusted monthly closing prices.

The good news is that the smaller capitalization ETFs seem to outperform the larger cap ETFs with a few exceptions: EWX underperformed EEM over 11 months and VBR (value small cap) underperformed SPY over that same time frame. While historical performance is no indication of future trends, the 10 year performance of IJR was 130% against just 34% for SPY.

Issues

This analysis does present a few issues. For several ETFs, there was really insufficient history to draw meaningful conclusions. Also, correlations probably converged towards 100% due to the recent financial crisis, which would encompass both the 30 month and 60 month windows. If you looked from January 2002 to December 2005, IJR had only an 80% correlation to SPY, rather than the 90+% posted above. Will this trend return in the future, or have securities uniformly become more correlated? This same observation can be applied to emerging markets as well, as I noted in an earlier article.

Conclusion

The rationale for purchasing smaller cap ETFs is for return benefits, not diversification. This appears to be quite true in U.S. markets and probably extrapolates to developed markets.

In developing markets, like Brazil and Latin America, there was really insufficient data to come to a clear conclusion. The indication was that smaller caps did not offer superior diversification as measured by portfolio volatility reduction. However, BRF over 20 months still had a very low correlation, around 60%, to SPY, which would result in volatility reduction of the portfolio if the 11 month volatilities remained the same over 20 months.

The growth small cap ETF outperformed the value small cap ETF over all time periods that were checked, despite the fact that two ETFs had similar volatilities and correlations to SPY.

This analysis will probably be more interesting in 1-2 years, once additional history is available on several small cap ETF options. It will also provide a perspective that is further removed from the events of 2008.

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. I may initiate a long position in BRF over the next 72 hours.

Source: Seeking Diversification Through Small Cap ETFs