Seeking Alpha
Solar, utilities, quantitative analysis, dividend investing
Profile| Send Message|
( followers)  

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
TickerNameAssets ($ millions)YieldGeographyFocus
SPYSPDR S&P 500 Trust ETF103,7302.0%U.S.Large Cap Index
IJRiShares S&P SmallCap 600 Index7,2801.3%U.S.Small Cap Index
PDNPowerShares FTSE RAFI Dev Markets ex-US Small/Mid562.1%ex - U.S. DevelopedSmall Cap
LATMMarket Vectors LatAm Small Cap Index ETF122.2%Latin AmericaSmall Cap
ILFiShares S&P Latin America 40 Index1,9503.1%Latin AmericaLarge Cap Index
BRFMarket Vectors Brazil Small-Cap ETF4573.8%BrazilSmall Cap
EWZiShares MSCI Brazil Index Fund12,6902.8%BrazilLarge Cap
VBKVanguard Small Cap Growth ETF8,7700.5%U.S.Growth
VBRVanguard Small Cap Value ETF7,0402.1%U.S.Value
XLUUtilities Select Sector SPDR6,6803.8%U.S.Large Cap Utilities
PSCUPowerShares S&P Small Cap Utility ETF303.6%U.S.Small Cap Utilities
EWXSPDR S&P Emerging Markets Small8332.2%EmergingSmall Cap
EEMiShares MSCI Emerging Markets Index34,5002.1%EmergingLarge Cap

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
Ticker24-Month Correlation36-Month Correlation48-Month Correlation
SPY100%100%100%
IJR96%93%94%
PDN90%90%92%
LATM82%NANA
ILF91%88%88%
BRF76%70%NA
EWZ87%84%84%
VBK96%93%95%
VBR97%95%96%
XLU25%49%65%
PSCU70%NANA
EWX84%81%86%
EEM89%88%90%

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
Ticker24 Month Volatility36 Month Volatility48 Month Volatility
SPY3.9%4.4%5.6%
IJR5.1%5.7%7.2%
PDN5.1%5.4%7.3%
LATM8.1%NANA
ILF6.6%7.0%9.0%
BRF9.4%9.1%NA
EWZ8.0%8.3%10.2%
VBK5.7%6.2%7.5%
VBR5.1%5.7%7.6%
XLU2.1%2.8%3.9%
PSCU2.8%NANA
EWX7.2%7.0%9.3%
EEM6.9%6.9%8.8%

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
Ticker12 Month return24 Month Return36 Month Return48 Month return
SPY18%40%46%19%
IJR16%45%55%23%
VBK-6%47%62%28%
VBR-14%34%46%18%
PDN-7%12%13%18%
LATM-23%-9%NANA
ILF-15%-1%20%1%
BRF14%-18%19%NA
EWZ14%-14%4%-13%
XLU11%28%39%13%
PSCU7%30%NANA
EWX-6%-7%16%12%
EEM-4%4%20%8%

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.

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.

Source: Small-Cap ETFs: Seeking Better Returns, Not Diversification