It’s been said that good things come in small packages. And to some extent that has been the case for investors holding small company stocks in recent years.
In 2018, small-cap exchange-traded funds like the iShares Core S&P Small-Cap ETF (IJR) mostly underperformed large caps but still managed to beat mid caps. IJR declined 8.5% while the SPDR S&P 500 ETF (SPY) fell 4.5%, but the SPDR S&P MidCap 400 ETF (MDY) sank 11.2%.
Despite recent struggles, small caps have outperformed their large- and mid-cap peers during the past three- and 10-year periods. Which small-cap ETFs are best for financial advisors to use on behalf of clients? And can small companies continue their impressive run?
Sizing Up The Market
Companies with a market capitalization from $250 million up to $3 billion are generally categorized as small caps. Because these types of stocks aren’t typically household names, the market for trading them tends to be thinner and more volatile. Also, while the promise of trying to identify the next Netflix or Starbucks is exciting, the risks of trying to pick the winners from the losers is high.
Small-cap ETFs provide a practical gateway for diversification, automatic portfolio rebalancing and affordable cost. Most funds are index-linked and market-cap weighted while a small minority are actively managed. Let’s examine the small-cap ETF marketplace.
Portfolio X-Ray
Many of the largest small-cap ETFs (by assets) are linked to the Russell 2000, a widely used benchmark. However, funds linked to it may not necessarily be the best choices.
For instance, widely held benchmark-tied funds like the $40.5 billion iShares Russell 2000 ETF (IWM) have consistently lagged small-cap peers. During the past 10 and 15 years, the iShares Core S&P Small-Cap ETF has gained 14% and 9%, respectively, compared to a gain of just 12.5% and 7.5% for IWM. In other words, ETFs linked to the S&P SmallCap 600 Index have trounced the funds that track the Russell 2000 Index through both good and bad equity markets. What’s behind the Russell’s lackluster results?
One common explanation involves the Russell 2000’s annual rebalancing. Because FTSE Russell provides advance disclosure of changes to the index’s holdings, hedge funds and traders can front run by snapping up stocks to be included in the reconstitution and sell them afterward for a quick profit. The result has been underperformance for many unsuspecting ETF investors.