Small-Cap ETFs: Seeking Better Returns, Not Diversification

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 |  Includes: BRF, EEM, EWX, EWZ, IJR, ILF, LATM, PDN, PSCU, SPY, VBK, VBR, XLU
by: Bennington Investment Ideas

Small-cap stocks are often seen as providing two major benefits: diversification and greater returns. However, are these assumptions true or just investing myth? This review will not be exhaustive by any measure since there are countless small-cap ETFs, and perhaps and even greater number of mutual funds. The goal of this article was to review some large-cap and small-cap ETFs with some variations on geography and investing style. The following ETFs were considered:

Select Small and Large Cap ETFs
Ticker Name Assets ($ millions) Yield Geography Focus
SPY SPDR S&P 500 Trust ETF 103,730 2.0% U.S. Large Cap Index
IJR iShares S&P SmallCap 600 Index 7,280 1.3% U.S. Small Cap Index
PDN PowerShares FTSE RAFI Dev Markets ex-US Small/Mid 56 2.1% ex - U.S. Developed Small Cap
LATM Market Vectors LatAm Small Cap Index ETF 12 2.2% Latin America Small Cap
ILF iShares S&P Latin America 40 Index 1,950 3.1% Latin America Large Cap Index
BRF Market Vectors Brazil Small-Cap ETF 457 3.8% Brazil Small Cap
EWZ iShares MSCI Brazil Index Fund 12,690 2.8% Brazil Large Cap
VBK Vanguard Small Cap Growth ETF 8,770 0.5% U.S. Growth
VBR Vanguard Small Cap Value ETF 7,040 2.1% U.S. Value
XLU Utilities Select Sector SPDR 6,680 3.8% U.S. Large Cap Utilities
PSCU PowerShares S&P Small Cap Utility ETF 30 3.6% U.S. Small Cap Utilities
EWX SPDR S&P Emerging Markets Small 833 2.2% Emerging Small Cap
EEM iShares MSCI Emerging Markets Index 34,500 2.1% Emerging Large Cap
Click to enlarge

Source: Yahoo Finance.

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. I first checked correlations to see if small-cap ETFs indeed offered lower correlations than corresponding large-cap ETFs.

Correlations to SPY
Ticker 24-Month Correlation 36-Month Correlation 48-Month Correlation
SPY 100% 100% 100%
IJR 96% 93% 94%
PDN 90% 90% 92%
LATM 82% NA NA
ILF 91% 88% 88%
BRF 76% 70% NA
EWZ 87% 84% 84%
VBK 96% 93% 95%
VBR 97% 95% 96%
XLU 25% 49% 65%
PSCU 70% NA NA
EWX 84% 81% 86%
EEM 89% 88% 90%
Click to enlarge

Source: Yahoo Finance data downloaded on Aug. 26, 2012, using split and dividend adjusted monthly closing prices. Author calculations.

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 5% points lower than EEM, which has more large-cap stocks. BRF was also somewhat lower than EWZ. However, it was also interesting to note that the U.S.-focused ETFs have very high correlations to SPY, ranging from 93% to 97%. This was consistent even when investing style was a variable in the cases of VBR and VBK.

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 24 Month Volatility 36 Month Volatility 48 Month Volatility
SPY 3.9% 4.4% 5.6%
IJR 5.1% 5.7% 7.2%
PDN 5.1% 5.4% 7.3%
LATM 8.1% NA NA
ILF 6.6% 7.0% 9.0%
BRF 9.4% 9.1% NA
EWZ 8.0% 8.3% 10.2%
VBK 5.7% 6.2% 7.5%
VBR 5.1% 5.7% 7.6%
XLU 2.1% 2.8% 3.9%
PSCU 2.8% NA NA
EWX 7.2% 7.0% 9.3%
EEM 6.9% 6.9% 8.8%
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Source: Yahoo Finance data downloaded on Aug. 26, 2012, using split and dividend adjusted monthly closing prices. Author calculations.

Given the substantially higher volatilities for the smaller-cap ETFs and the almost comparable correlations, it is clear that these small-cap ETFs provide no incremental diversification benefit. Only EWX, using the 36-month data, shows a slight benefit relative to its larger-cap cousin, EEM. However, the benefit is 0.06%, which is approximately 1% of the volatility of SPY. Furthermore, I would not be surprised if this result is statistically irrelevant, especially noting this only happened using 36-month values and not for 24- or 48-month values.

So if small-cap ETFs do not provide better diversification benefits, why even consider them? Perhaps they provide better returns.

Total Return
Ticker 12 Month return 24 Month Return 36 Month Return 48 Month return
SPY 18% 40% 46% 19%
IJR 16% 45% 55% 23%
VBK -6% 47% 62% 28%
VBR -14% 34% 46% 18%
PDN -7% 12% 13% 18%
LATM -23% -9% NA NA
ILF -15% -1% 20% 1%
BRF 14% -18% 19% NA
EWZ 14% -14% 4% -13%
XLU 11% 28% 39% 13%
PSCU 7% 30% NA NA
EWX -6% -7% 16% 12%
EEM -4% 4% 20% 8%
Click to enlarge

Source: Yahoo Finance data downloaded on Aug. 26, 2012, using split and dividend adjusted monthly closing prices. Author calculations.

The above table shows the returns over a range of periods from one to four years. The results are inconclusive. Until the past year, the results for the U.S. small caps appear to be more favorable. I would also not expect there to be a consistent trend; otherwise, investors would uniformly choose small caps over large caps, bidding up their price and limiting future returns -- rendering the initial thesis false.

Conclusion

It seems clear that the rationale for pursuing small-cap stocks should be around returns and not diversification benefits, since those are non-existent. Furthermore, it is not a sure thing that small caps will outperform larger-cap stock ETFs. This is consistent across geographies and sectors. Having previously examined this subject, I came to the same conclusion. This analysis reflects an updated look and covers greater data histories for some of the newer ETFs, like LATM, BRF, and PSCU. However, it should be noted that this is just one set of small- and large-cap ETFs. There might be other pairs that support the diversification thesis. The other item that falls outside of this analysis is that small-cap ETFs were almost always more volatile than their larger-cap cousins.

Disclosure: I am long BRF, EWZ, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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 have recently reduced my exposure to small capitalization stocks in various mutual funds.