Boosting Returns With Small Cap ETFs

by: Bennington Investment Ideas

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 since there are countless small capitalization ETFs, let alone the additional funds and individual securities that a casual investor can use. The following ETFs were considered:

Select ETFs

Ticker Name Assets Geography Type
SPY SPDR S&P 500 Trust ETF 81,230 U.S. Large Cap Index
IJR iShares S&P SmallCap 600 Index 5,550 U.S. Small Cap Index
PDN PowerShares FTSE RAFI Dev Markets ex-US Small/Mid 63 ex - U.S. Developed Small Cap
LATM Market Vectors LatAm Small-Cap Index ETF 15 Latin America Small Cap
ILF iShares S&P Latin America 40 Index 1,560 Latin America Large Cap Index
BRF Market Vectors Brazil Small-Cap ETF 595 Brazil Smalll Cap
EWZ iShares MSCI Brazil Index Fund 9,110 Brazil Large Cap
VBK Vanguard Small Cap Growth ETF 6,970 U.S. Growth
VBR Vanguard Small Cap Value ETF 5,670 U.S. Value
XLU Utilities Select Sector SPDR 6,600 U.S. Large Cap Utilities
PSCU PowerShares S&P SmallCap Utility ETF 43 U.S. Small Cap Utilities
EWX SPDR S&P Emerging Markets Small 909 Emerging Small Cap
EEM iShares MSCI Emerging Markets Index 27,470 Emerging Large Cap
JSC SPDR Russell/Nomura Small Cap Japan ETF 99 Japan Small Cap
EWJ iShares MSCI Japan Index Fund 6,620 Japan Large Cap
GDX Market Vectors Gold Miners ETF 8,950 Various Large Cap
GDXJ Market Vectors Junior Gold Miners ETF 2,090 Various Small Cap
Source: Yahoo Finance downloaded on October 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 (SPY). The first analysis was to check correlations to see if small cap ETFs indeed offered lower correlations than corresponding large capitalization ETFs. I reviewed this over several different time frames since some ETFs had more limited history.

ETF Correlations

Ticker 15 Month Correlation 24 Month 36 Month
SPY 100% 100% 100%
IJR 97% 94% 94%
PDN 94% 92% 91%
ILF 91% 91% 85%
BRF 76% 75% NA
EWZ 90% 90% 81%
VBK 98% 95% 94%
VBR 99% 96% 96%
XLU 54% 63% 58%
EWX 84% 83% 82%
EEM 91% 91% 88%
JSC 44% 48% 59%
EWJ 68% 72% 77%
GDX 29% 28% 15%

Source: Author Calculations

In most cases, it appears that the small cap ETF version had slightly but not significantly lower correlations. The two counter examples were for gold mining (GDX, GDXJ) and utilities (XLU, PSCU). The counter example to being just slightly lower was Japan where JSC had a 40-60% correlation while EWJ had a 65-80% correlation over the different time frames.

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 two time frames.

ETF Volatilities

Ticker 15 Month 36 Month
SPY 5.2% 5.6%
IJR 6.9% 7.4%
PDN 6.0% 7.2%
LATM 8.8% NA
ILF 8.2% 8.5%
BRF 10.1% NA
EWZ 9.6% 9.7%
VBK 7.7% 7.5%
VBR 6.8% 7.8%
XLU 1.9% 3.6%
PSCU 3.3% NA
EWX 8.2% 9.1%
EEM 8.6% 8.7%
JSC 4.0% 5.6%
EWJ 4.9% 5.8%
GDX 7.1% 10.9%
GDXJ 10.8% NA

Source: Author Calculations

This table largely confirms intuition that small cap ETFs have higher volatilities than there larger cap counterpart. However, this is again not true for Japan where JSC had lower volatility than EWJ and it also was not consistent for emerging markets in looking at EWX and EEM. These two tables make it evident that except for Japan, the addition of small cap ETFs will not lower portfolio volatility relative to their larger cap counter parts. The slight correlation benefit is trumped by the often substantially larger volatility.

One additional comment might be around looking at the correlations between the small cap ETF and large cap ETF. While it is very solid to compare the small cap U.S. ETFs to SPY, does it make as much sense to compare both BRF and EWZ to SPY. What about the correlation between BRF and EWZ? The following table answers these questions and shows that the two variants are usually highly (90+%) correlated. However, XLU and PSCU show a relatively lower correlation, which I will address later.

Pairs Correlations

Pairs Correlation
BRF, EWZ 90.2%
LATM, ILF 93.5%
XLU, PSCU 81.4%
JSC, EWJ 90.1%
GDX, GDXJ 90.2%
EWX, EEM 96.7%

Source: Author Calculations. Time frames were varied to use at most 36 months or whatever history was available.

The final question is to look at returns to see how the ETFs compare. I pulled returns over a few different time frames. Again, unfortunately, not all ETFs had sufficient history for each time frame.

ETF Returns

Ticker March 2009- present 12 month 6 month
SPY 69% 11% -5%
IJR 95% 14% -8%
PDN 94% 1% -12%
LATM NA -15% -21%
ILF 94% -8% -12%
BRF NA -14% -17%
EWZ 87% -12% -16%
VBK 109% 15% -10%
VBR 95% 8% -11%
XLU 51% 15% 8%
PSCU NA 15% 4%
EWX 86% -20% -19%
EEM 78% -6% -14%
JSC 48% 14% 1%
EWJ 30% 1% -4%
GDX 66% 6% -3%
GDXJ NA -3% -22%

Source: Author calculations

The synthesis here is that the small cap version tends to provide more extreme returns - greater declines and greater increases. The one exception was JSC which outperformed EWJ in all three time frames.

Small Cap ETFs Are For Returns, Not Diversification

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 other developed markets. It seems to be true in many developing markets as well. It is also clear that small cap ETFs often carry more risk as noted by their higher volatilities and more extreme returns.

However, there seem to be exceptions to the rule. First, there does not seem to be a compelling reason to purchase PSCU over XLU. This analysis shows it to have a higher risk profile with worse returns. PSCU also has relatively few assets and is thinly traded. Furthermore, it tends to be more focused on gas utilities than electric or integrated which dominate XLU.

For investors interested in Japan with a relatively passive approach, it seems that one should definitely look at small cap ETFs as well as and possibly to the exclusion of large cap ETFs. While it is not clear why they should be superior on both return and risk, the numbers support it. One caution is that it is smaller and more thinly traded.

Finally, EWX could be an interesting option for investors looking at emerging markets. While it is more thinly traded than EEM, which is highly liquid, it still has reasonably volume (better than either PSCU or JSC).

Disclosure: I am long EWZ, SPY, BRF.

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.

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