When choosing a core small-cap ETF holding, investors prefer the most well-known, heavily traded, most liquid, and one of the lowest cost selections: iShares Russell 2000 ETF (NYSEARCA:IWM).
The IWM is obviously widely diversified with 2000 stocks. Specifically, it represents the smallest 2,000 stocks out of the 3,000 largest market capitalization stocks in the market. It comprises but 8% of the Russell 3000. Many investors select it as a core portfolio holding. If other small-cap investments can't beat these benchmarks, the conventional wisdom says, then just stick with the ETF that represents that benchmark.
But there other small-cap ETFs that offer diversification, performance, and costs that can compete with IWM, and that's not because of superior long-term returns, but superior long-term risk-adjusted return.
It's easy to do a screen and just invest in a benchmark or in a fund or ETF that has outperformed a benchmark over a certain period of time. The problem is that these total return numbers is where most investors stop their research.
Fortunately, there is something called The Sharpe Ratio. According to AAII:
When analyzing the Sharpe ratio, the higher the value, the more excess return investors can expect to receive for the extra volatility they are exposed to by holding a riskier asset. Similarly, a risk-free asset or a portfolio with no excess return would have a Sharpe ratio of zero.
AAII also mentions that one can't look at the Sharpe Ratio for one investment, but rather as a tool to compare risk-adjusted return between two investments.
IWM vs. SPDR Russell 2000 Low Volatility ETF (NYSEARCA:SMLV)
Here's the rundown of the IWM. It's loaded with $27.4 billion in assets and its top three holdings are Advanced Micro Devices (NASDAQ:AMD), Microsemi Corp (NASDAQ:MSCC) and IdaCorp (NYSE:IDA), which account for a little over 0.7% of assets. It is highly liquid, trading 35 million shares daily, based on the average 3-month volume. The bid-ask is tight, and the expense ratio is 0.2%.
IWM has the following returns:
Since 2/25/13: 37.06%
The Sharpe ratio is 0.52.
However, SMLV has it beat.
SPDR describes the strategy for SMLV as follows:
The Index includes small cap U.S. equity securities and is designed to capture stocks with low volatility. Volatility is a measure of a security's variability in total returns based on its historic behavior. A low volatility index is considered to have a lower return variability than the overall market and can be used by investors to adjust volatility exposure in a portfolio. To construct the Index, the Index starts with the Russell 2000 Index, which measures the performance of the small cap segment of the U.S. equity universe. The Index captures securities with focused exposure to low volatility, while minimizing exposure to non-target factors. The Index contains no more than 400 securities and is reconstituted monthly to maintain its focus on low volatility. Unlike more traditional equity market indexes which seek to track the performance of a specific segment of the equity market, the Index is intended to provide a specific factor exposure.
The fund holds 359 stocks, so it is diversified but obviously more concentrated than the IWM. It is not much smaller than IWM with $8 billion of assets under management. It's top three holdings, and many of its others, are far more familiar names than held by IWM. SPLV holds AT&T (NYSE:T), Waste Management (NYSE:WM) and PepsiCo (NYSE:PEP), which account for about 3.75% of assets.
While not as liquid, it still has a robust 3-month average daily trading volume of 2.3 million shares. The expense ratio is 0.25%, so it is only 5 bps higher than IWM, and more than offset by the superior returns.
SMLV has the following returns:
Since 2/25/13: 32.95%
The Sharpe Ratio, however, is 1.34. That's substantially higher. Not coincidentally, we also discover Morningstar rates SPLV as a 5-star fund with below average risk and high returns vs. IWM's 3-stars, above average risk, and only average returns.
There's another lesson here. Most investors might reflexively believe that more diversification automatically equals less risk. That may be true, but it can also dampen returns.
So don't just default for the benchmark index. There are so many ETFs out there that it's possible you will find better risk-adjusted returns. We'll try and highlight some of these going forward, but we'll also find that sometimes benchmarks really are the best choice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.