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Making Sense Of Small Cap ETFs Part 1

Summary

The wide variety of offerings in the U.S. Small Cap ETF market makes it difficult to compare and choose one ETF over another.

This article organizes small cap ETFs according to their index, and places them into categories according to the various ways that they slice and dice it. This allows valid comparisons.

I discuss how the construction of the underlying indexes affects the fund performance.

The wide variety of offerings in the U.S. Small Cap ETF market makes it difficult to compare and choose one ETF over another. There are more than two dozen ETFs based on one of the two major indexes, that is, the Russell 2000 or the S&P Small Cap 600. Some of these ETFs simply track the underlying market cap weighted indexes, others use different weighting schemes. Some narrow the broad market according to investment style, that is, value or growth. Others are further refined into pure value and pure growth. There is quite a bit of overlap between fund families and in some cases there is essentially no difference between one fund and another. These funds make up about half of the market for small cap ETFs. The other half consists of funds using indexes that take a variety of approaches to stock selection and weighting. For the most part, each fund family in this group has chosen their own approach that differs in some way from the major market indexes and there is little overlap between funds.

This article discusses the first group of funds, those based on the broad market indexes.

Table 1 lists funds based on the leading broad-market indexes:

  1. The Russell 2000 Index, used by many providers,
  2. The S&P Small Cap 600 Index, also used by many,
  3. The CRSP U.S. Small Cap Index, used by Vanguard, and
  4. The Dow Jones U.S. Small Cap Index, used by Schwab.

Table 1. Small Cap ETFs

 

Russell 2000

S&P 600

CRSP

Dow Jones

Broad-based

Market-weighted

iShares

IWM

IJR

   

SPDR

TWOK

SLY

   

Vanguard

VTWO

VIOO

VB

 

Schwab

     

SCHA

 

Equal-weighted

Powershares

EQWS

     

Guggenheim

 

EWSC

   
 

Fundamental-weighted

Schwab

FNDA

     
 

Revenue-weighted

Oppenheimer

 

RWJ

   
 

Style

Growth

iShares

IWO

IJT

   

SPDR

 

SLYG

   

Vanguard

VTWG

VIOG

VBK

 
 

Value

iShares

IWN

IJS

   

SPDR

 

SLYV

   

Vanguard

VTWV

VIOV

VBR

 
 

Pure Style

Growth

       

Powershares

PXSG

     

Guggenheim

 

RZG

   
 

Value

Powershares

PXSV

     

Guggenheim

 

RZV

   
 

Dividend Growth

ProShares

SMDV

     

The first thing to notice is the overlap in the broad-based, market-cap weighted category. Each of the major fund families have ETFs based on both the Russell 2000 and the S&P 600. In these cases fund performance differs only with respect to fees and tracking error.

Table 2 shows the percentage change in the broad-market funds relative to the Russell 2000 over various time periods as of April 30, 2016. It shows how much each ETF has gained or lost in a particular time period and the difference relative to the Russell 2000. A careful reader will notice that the differences don't always add up exactly. This is because the difference is calculated as a relative strength ratio and not the arithmetic difference. Where multiple fund families use the same index, I have used the iShares ETFs to avoid duplication.

Table 2 Small Cap ETF Performance Relative to Russell 2000 April 30, 2016 (Percent)

   

1 Month

3 Months

6 Months

1 Year

Russell 2000

IWM

+1.97

+9.57

-2.21

-7.82

           

S&P 600

IJR

+1.41

+10.67

+1.14

-1.65

vs. IWM

 

-0.55

+1.00

+3.43

+6.70

           

CRSP (Vanguard)

VB

+2.12

+11.23

+0.05

-5.47

vs. IWM

 

+0.15

+1.51

+2.31

+2.56

           

Dow Jones (Schwab)

SCHA

+2.22

+11.18

-0.50

-6.42

vs. IWM

 

+0.24

+1.47

+1.75

+1.52

From Table 2 we see that there are major differences in performance between the indexes. For example, during the 1-Year period the S&P 600 outperformed the Russell 2000 by 6.70 percent. The CRSP and Dow Jones indexes performed better than the Russell 2000, but not as well as the S&P 600. To understand the differences in performance, we have to look into the stock selection criteria used by the index providers.

All of the index providers have some basic requirements that a stock must meet in order to be included in the index. All of the indexes consist of common stocks and REITs that are U.S. companies traded on major stock exchanges. Beyond that, the different indices vary with respect to several factors:

  • Minimum market capitalization,
  • Minimum trading volume
  • Amount of float available to the public
  • Breakpoints
  • Number of stocks included in the index
  • Reconstitution
  • Fundamentals

Russel 2000 vs S&P 600

The Russell 2000 is a total stock market index, or more accurately, a subset of a total market index. FTSE Russell starts with a market universe of 4000 stocks that meet their eligibility requirements. These are ranked by market-capitalization. Stocks ranked 1000 - 3000 are included in the index, which is reconstituted quarterly. Eligibility requirements include:

  • Minimum market-capitalization: > $30M
  • Minimum trading volume: none
  • Publicly available float: > 5%

The S&P 600 is constructed quite a bit differently. Rather than a mechanical market-cap selection process, the stocks in the S&P 600 are selected by a committee. Standard & Poors starts with a range of market capitalization from $400M to $1.8B. The eligibility requirements are much higher:

Minimum trading volume:

  • Annual trading volume/float =1,
  • 250,000 shares per month for six months.
  • Publicly available float: > 50%

Financial viability:

  • The sum of as-reported GAAP earnings for the past four quarters must be positive,
  • Most recent quarter GAAP earnings must be positive,
  • Reasonable balance sheet leverage

Contribution to sector balance maintenance.

Reconstituted as needed.

CRSP and Dow Jones

Like the Russell 2000, The CRSP and Dow Jones indexes are total stock market indexes using a mechanical selection process. Both have minimal requirements for liquidity and float. Both start with a total stock market ranked by market-capitalization. They differ mainly in their approaches to breakpoints and the number of stocks in the index. The Dow Jones index consists of 1750 stocks ranked 750 - 2500 by market-cap. CRSP does not have a limit on the number of companies in the index. Their breakpoints are based on a percentage of total market capitalization. The top 85% of total market-capitalization goes into their large cap index. The small cap index includes stocks from 85% - 98% of total market-cap.

Conclusion

Standard & Poors more rigorous stock selection process has clearly out-performed the total stock market indexes during the past year. Since this is the only one of these indexes to incorporate financial viability requirements, it is reasonable to assume that this is the major contributing factor. The larger size and greater liquidity requirements are probably contributing factors. The relative out-performance of the Dow Jones and CRSP indexes compared to the Russell 2000 is probably due to the inclusion of larger and more liquid companies.

This article has only touched on the major broad-market indexes. Future articles will discuss the performance of the different weighting schemes and style indexes, and other ETFs not based on the major indexes.

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.