Alternative Small-Cap ETFs In Place Of iShares IJR Offering

Source: photo

Introduction

As I stated in my review of mid-cap ETFs (article), with the focus on large-cap stocks, the small-cap universe is also not on every investor’s buy list. Even recent IPOs land in the mid to large cap universe, drawing more attention away from small-cap stocks. This is evident when looking at recent performance charts.

ChartData by YCharts

Since late 2018, when large Tech stocks started to dominate the market, SPY has outperformed iShares Core S&P Small-Cap ETF (NYSEARCA:IJR). Prior to that, IJR was performing better, though with higher risk.

ChartData by YCharts

Using PortfolioVisualizer data, we can see small-cap doing better back to 1972.

Source: portfoliovisualizer.com

Professionals have speculated about why Small-cap stocks have provided better returns. Some possibilities are:

  • Unlike large-cap stocks, fewer analysts follow small-cap stocks, resulting in a greater possibility of mispricing.
  • It is much easier to grow from 10m to 100m in sales than from 100m to 1b, providing more opportunity for price appreciation.
  • Being smaller, there is more risk in these companies. Financial theory says investors expect and should earn a return premium for taking on that added risk.
  • SEC rules require institutions to file reports when owning 5% of the shares of any company. This limits what many large institutions might want to own, and the small percent allocation doesn’t benefit them enough to spend money analyzing this universe. This leaves this universe to smaller firms or individual investors more prone to active trading.

Source: ETF Research Center

The current sector differences help explain SPY’s recent outperformance as it held a much higher weight in Tech than IJR does. Keep this in mind as we will do the same sector review with the ETFs I will compare IJR against.

Does the Index matter?

As important as the ETF’s name is, the benchmark/index they chose to invest against is critical to analyze. iShares Core S&P Small-Cap ETF uses the S&P SmallCap 600 Index whereas two other generic ETFs supposedly in this space are more questionable. The Vanguard Small-Cap ETF (NYSEARCA:VB) uses the CRSP US Small Cap Index, which includes 1,388 stocks and only 16% are classified as small cap by ETFRC. The other well-known one in this space is the iShares Russell 2000 ETF (NYSEARCA:IWM), which uses the Russell 2000 index, covering roughly 2.000 stocks, of which only 52% are classified as small cap. Even the index used by IJR, ETFRC only classifies 65% as small cap, but it does have the smallest weighted average market cap, $1.7b, which is a third of the WMC of VB’s holdings. Each provider decides what market size qualifies for the size-based indices. My point is, the name can be misleading, and understanding the underlying index is critical.

ETF Comparisons

Let’s start with the ETF the others will be measured against.

IJR: iShares Core S&P Small-Cap ETF

iShares Trust – iShares Core S&P Small-Cap ETF is an exchange traded fund launched by BlackRock, Inc. The fund is managed by BlackRock Fund Advisors. The fund invests in public equity markets of the United States. It invests in stocks of companies operating across diversified sectors. It invests in growth and value stocks of small-cap companies. The fund seeks to track the performance of the S&P SmallCap 600 Index, by using representative sampling technique. iShares Trust – iShares Core S&P Small-Cap ETF was formed on May 22, 2000

Source: Seeking Alpha modified

Expense ratio: 0.06% AUM: $40b Yield: 1.7%

XSLV: Invesco Exchange-Traded Fund Trust II – Invesco S&P SmallCap Low Volatility ETF

Invesco Exchange-Traded Fund Trust II – Invesco S&P SmallCap Low Volatility ETF is an exchange traded fund launched and managed by Invesco Capital Management LLC. It invests in public equity markets of the United States. It invests in stocks of companies operating across diversified sectors. It invests in volatile stocks of small-cap companies. It seeks to track the performance of the S&P SmallCap 600 Low Volatility Index, and was formed on February 15, 2013.

Source: Seeking Alpha modified

Expense ratio: 0.25% AUM: $1.5b Yield: 2.4%

Source: PortfolioVisualizer

When it was needed most, XSLV failed its purpose of providing lower volatility. In March, XSLV lost 25.6%, while IJR only lost 22.5%. That said, before 2020, XSLV provided a better return (13.3% vs 12.2%) with lower risk (12.7 vs 15.3).

Source: ETFRC.com

I have to say the sector drift seems the opposite of what I would expect between the standard ETF and a low volatility one. In my mind, Tech is a volatile sector. Consumer Discretionary being underweighted makes sense in a year where incomes were cut or uncertain. What doesn’t is, Morningstar classifies XSLV as small growth focused, not what I would expect from this ETF. XSLV universe is only 20% of what IJR includes, so reviewing the index’s selection rules is important to know how they measure risk.

DWAS: Invesco Exchange-Traded Fund Trust II – Invesco DWA SmallCap Momentum ETF

Invesco Exchange-Traded Fund Trust II – Invesco DWA SmallCap Momentum ETF is an exchange traded fund launched and managed by Invesco Capital Management LLC. The fund invests in public equity markets of the United States. It invests in stocks of companies operating across diversified sectors. It invests in momentum stocks of small-cap companies. The fund seeks to track the performance of the Dorsey Wright SmallCap Technical Leaders Index, and was formed on July 19, 2012.

Source: Seeking Alpha modified

Expense ratio: 0.60% AUM: $224m Yield: 0.35%

Source: PortfolioVisualizer

Like the next choice, this momentum-focused ETF has failed to provide the CAGR IJR has and managed to do that with greater risk.

Source: ETFRC.com

This ETF has an investable universe that differs from IJR as seen in the low overlap in weight (14%) and assets owned (29%), plus the number of stocks held is only a third of what IJR holds. With IJR already underweight Tech stocks, its surprising DWAS is even more, and that Health is the most underweighted sector in a market segment filled with small medical companies working on COVID-19 solutions.

DGRS: WisdomTree Trust – WisdomTree U.S. SmallCap Quality Dividend Growth Fund

WisdomTree Trust – WisdomTree U.S. SmallCap Quality Dividend Growth Fund is an exchange traded fund launched by WisdomTree Investments, Inc. It is co-managed by Mellon Investments Corporation, WisdomTree Asset Management, Inc. The fund invests in public equity markets of the United States. The fund invests in stocks of companies operating across diversified sectors. It invests in growth stocks of small-cap companies. It invests in dividend paying stocks of companies. The fund seeks to track the performance of the WisdomTree U.S. SmallCap Quality Dividend Growth Index, and was formed on July 25, 2013.

Source: Seeking Alpha modified

Expense ratio: 0.38% AUM: $94m Yield: 2.6%

Source: PortfolioVisualizer

Even income investors should skip this dividend growth ETF as it barely yields more, and its CAGR and StdDev are both trailing what IJR has delivered.

Source: ETFRC.com

With 55% of its holdings not in IJR, it shows the two benchmarks definitely are following different strategies. Unfortunately, for investors, this ETF is not delivering the goods.

EWSC: Invesco Exchange-Traded Fund Trust – Invesco S&P SmallCap 600 Equal Weight ETF

Invesco Exchange-Traded Fund Trust – Invesco S&P SmallCap 600 Equal Weight ETF is an exchange traded fund launched and managed by Invesco Capital Management LLC. It invests in public equity markets of the United States. It invests in stocks of companies operating across diversified sectors. It invests in growth and value stocks of small-cap companies. The fund seeks to track the performance of the S&P SmallCap 600 Equal Weight Index, by using full replication technique. Invesco Exchange-Traded Fund Trust – Invesco S&P SmallCap 600 Equal Weight ETF was formed on December 3, 2010.

Source: Seeking Alpha modified

Expense ratio: 0.4% AUM: $23m Yield: 1.2%

Source: PortfolioVisualizer

So, even in the world of small-cap stocks, the larger ones are performing better and with less risk.

www.etfrc.com

Source: ETFRC.com

As expected, the universe of own assets completely matches, but with equal weighting in effect, only 71% of the weights overlap. EWSC equal weighting results in a larger allocation to Industrials and a big drop in Energy stocks.

Portfolio Strategy

One of my early articles examined how the difference asset sizes and growth/value allocations can deliver Alpha (article) which showed the benefits of thinking “small”. Another showed you could earn the same CAGR with a lower equity ratio by adding mid, small, and micro-cap stocks to one’s allocation (article).

With large Tech firms accounting for 25%+ of SPY, one factor investors get by going “small” is less exposure in that sector by adding small-cap funds to their asset allocation. While that has caused these ETFs to underperform since 2018, they have held their own since March.

If this small sample of ETFs within the small-cap universe is truly representative, there are limited opportunities to gain extra Alpha by deviating away from the ETFs based on the primary indices in this market segment. Except for XSLV prior to 2020, none shows a history of better CAGR or lower risks. Since I like investing on small-cap stocks, I will keep searching and will report if I find a good alternative to IJR.

Digging Deeper Links

Recent SA article:

Is it time for Small Stock?

why-you-should-consider-small-cap-index-funds

risks/rewards of small-cap-stocks

Large vs Small Stocks – an analysis of performance

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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.

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