The iShares Russell 2000 Value ETF (NYSEARCA:IWN) is a U.S. small-cap value index ETF. Small-cap value stocks are the cheapest U.S. equity industry sub-segment, and could outperform as valuations continue to normalize across the market. Small-cap value stocks are also significantly riskier than average, and would likely underperform if economic conditions were to worsen. IWN is a buy, but only appropriate for more aggressive investors. With a measly 1.8% yield, the fund is simply not an effective income vehicle.
IWN is an index ETF investing in U.S. small-cap value stocks. The fund tracks the Russell 2000 Value Index, an index of these same securities. It is a relatively simple index, which starts by selecting all U.S. equities that meet a very basic set of price, liquidity, trading, and voting rights criteria. Applicable stocks are then ranked according to their market-cap, with the index including stocks ranked #1,001-#3,000. These effectively comprise the U.S. small-cap equity universe. FTSE provides investors with the following table summarizing the situation:
The index then ranks these 2000 stocks according to their price to book ratio, past earnings growth, and future expected growth. Value stocks, those with the lowest scores in these three quantitative metrics, are then included in the index. Weights take into consideration valuations, with lower valuations equaling greater weights. This is a simplified account of how the system works. There are quite a few extra, unnecessarily complex kinks and calculations too, but these are not all that important, in my opinion at least.
IWN's underlying index is meant to focus on small-cap value stocks, and it accomplishes said goal, with the fund sporting a lower valuation and weighted average market-cap than its peers.
IWN's underlying index is quite broad, which results in a reasonably well-diversified fund. IWN invests in over 1,000 securities from all relevant industry segments. Largest holdings and industry weights are as follows.
As with most other small-cap and value funds, IWN is overweight most slow-growing, old-economy industries, including financials, industrials, real estate, and energy, but underweight the high-growth, expensive tech industry. As such, the fund's relative performance is strongly dependent on the relative performance of these industries, especially tech. IWN tends to outperform when tech underperforms, as has been the case YTD, in which industry valuations have started to normalize.
The opposite is true as well. IWN tends to underperform when tech outperforms, as was the case during 2020, when the coronavirus pandemic was in full swing.
In my opinion, IWN's industry exposures are neither a positive nor a negative, but are an important factor for investors to consider. Tech bulls should probably look for alternatives to IWN, while investors concerned about frothy tech valuations could consider an investment in the fund.
Besides the above, not much else stands out about IWN, its strategy or holdings. It is a U.S. small-cap value index ETF, and its holdings and characteristics reflect that.
IWN's investment thesis is remarkably simple. The fund sports an incredibly cheap valuation, which could lead to significant, market-beating returns if valuations normalize. IWN itself sports a PE ratio of 10.9x and a PB ratio of 1.4x, around half that of most broad-based U.S. equity indexes. It is an incredibly cheap valuation, all things considered.
Importantly, small-cap value stocks currently sport the cheapest valuations out of all equity industry sub-segments, on both an absolute and historical basis. Small-cap value is cheapest amongst its peers, and cheaper than it has been in the past, a solid combination.
In my opinion, the fact that these stocks are cheaper on a historical basis is of particular importance. Small-cap value stocks always trade with lower valuations than growth stocks, but the gap is wider than average, and by a reasonably large margin. Growth stocks are 40% more expensive than their historical average, while small-cap value stocks are currently 14% cheaper than the same, for a +50% valuation gap between these segments. This is a massive gap, and quite rate too, but not without precedent. Growth stocks were even more expensive during the dot-com bubble, at least until the bubble burst.
In my opinion, valuation gaps like the above are unlikely to persist into the future. Markets are mostly rational, especially in the long-term, and the historical precedent does seem to indicate that these massive gaps are unsustainable. Importantly, valuations have started to normalize. As can be seen above, valuations gaps were widest a few months / weeks ago, and have started to creep back up as of late. Normalization has mostly consisted of significant losses and underperformance in the tech industry, with small-caps themselves suffering lower than average losses.
Insofar as valuations continue to normalize, IWN should continue to outperform relative to most broad-based equity indexes. Sooner or later equity markets will recover, and said outperformance should translate into significant, market-beating returns for the fund and its shareholders, a significant benefit for the same.
As an aside, IWN has significantly outperformed relative to most broad-based equity indexes, including the S&P 500, since inception. In my opinion, the forward-looking analysis above is of significantly greater importance than the fund's past performance track-record, but it is an outstanding performance track-record regardless, and something for investors to keep in mind.
IWN is a strong fund and investment opportunity, but it is not one without drawbacks. Three stand out.
First is the fact that small-cap value companies tend to be significantly riskier than average. Smaller companies generally have comparatively weak balance sheets, less diversified revenue streams, and fewer, more expensive financing options. Value stocks are also generally riskier and of lower quality: they wouldn't be trading at low prices and valuations otherwise. Small-cap value stocks have all the negatives of both small companies and value stocks, and so are significantly riskier than average. Expect significant, above-average losses during downturns and recessions.
As an example of the above, we have Chesapeake Energy (CHK), the fund's third-largest holding. CHK is an energy company. Revenues are not that diversified, and the company is strongly dependent on energy prices for its revenues, earnings, and cash-flows. Losses could mount during a downturn, as occurred in early 2020. Losses could lead to significant losses, even defaults, as was the case in mid-2020, with the company filing for Chapter 11 bankruptcy protection in June of the same year. Conditions have materially changed since, so CHK is not currently at any real risk of bankruptcy, but it seems clear that the fund's holdings are incredibly risky.
Second is the fact that IWN's performance is strongly dependent on (fickle) market sentiment, and there is no guarantee that sentiment will be kind to the fund or its underlying holdings. Although this is true for almost all investments, it is particularly true of IWN. Some funds or investments might have strong dividends, which ensure some amount of returns regardless of market conditions, but IWN only yields 1.8%. Other funds or investments might engage in significant shareholder buybacks, which act as a catalyst for higher share prices and capital gains, but IWN's holdings do not do so in any significant capacity. IWN's performance is almost entirely dependent on the market, and as the saying goes, markets can remain irrational longer than you can stay solvent.
Third, and somewhat related to the above, is the fact that IWN has underperformed relative to most broad-based U.S. equity indexes since around 2017. Underperformance is quite significant, but almost entirely centered on 2019-2020, during which tech soared.
IWN's cheap valuation should lead to strong, market-beating returns moving forward, but that has not been the case in the past, and it could very well not be the case in the future.
On a more positive note, the fund's performance has improved YTD, so the situation seems to finally be changing course.
In my opinion, IWN's positives outweigh its negatives, but the fund does have its fair share of negatives.
IWN invests in U.S. small-cap value equities, the equity market subsegment with the cheapest valuation. The fund is a buy, but generally only appropriate for more aggressive investors.
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Juan has previously worked as a fixed income trader, financial analyst, operations analyst, and economics professor in Canada and Colombia. He has hands-on experience analyzing, trading, and negotiating fixed-income securities, including bonds, money markets, and interbank trade financing, across markets and currencies. He focuses on dividend, bond, and income funds, with a strong focus on ETFs, and enjoys researching strategies for income investors to increase their returns while lowering risk.
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