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Dissecting the 4 Most Popular Small-Blend ETFs

The four largest small-blend exchange-traded funds each have something to offer passive investors looking to overweight small-cap stocks.

Michael Rawson, CFA, 08/09/2013

Small-cap stocks have been on fire this year, with the Russell 2000 Index of small-cap stocks returning 24.0% through July compared with 19.6% for the S&P 500 Index. Small caps make up less than 15% of the U.S. equity market, but over the long term, small-cap stocks have outperformed large-cap stocks. According to the Ibbotson SBBI 2013 Classic Yearbook, large-cap stocks have returned 9.8% between 1926 and 2012, while small caps returned 11.9%, resulting in a small-cap premium of about 1.9%. To exploit this premium, many investors choose to overweight small caps.

Among ETFs in the small-blend category, 93% of the assets are held in just four funds, iShares Russell 2000 Index IWM, iShares Core S&P Small-Cap ETF IJR, Vanguard Small Cap ETF VB, and Schwab U.S. Small-Cap ETF SCHA. These funds are fairly similar, offering diversified, market-cap-weighted exposure to small-cap stocks at low expense ratios. But each follows a different index and each has features that make them appealing to different investors.

 

iShares Russell 2000 Index IWM is by far the largest and most liquid small-cap ETF. It trades more than $3 billion in an average day, which speaks to its popularity among institutional users looking to quickly gain access to small-cap stocks. The Russell 2000 Index that this fund follows covers approximately the 2,000 smaller stocks after the largest 1,000 from the Russell 1000 Index. This results in the smallest average market cap among the four indexes and the most exposure to micro-cap stocks.

Because it is one of the oldest small-cap indexes, with broader, more transparent coverage of small caps than the S&P SmallCap 600 Index, it is frequently used as a benchmark by small-cap fund managers. While fund managers want a benchmark that is a pure, unbiased representation of the asset class they represent, they also want a benchmark that is easy to beat. Over the past 18 years, the Russell 2000 has underperformed the S&P SmallCap 600. The below chart shows that the other three indexes have had similar performance, but the Russell 2000 Index stands out as a laggard. Russell may be a victim of its own success. Because so much money is tied to it, index arbitrageurs have historically been able to front run the index changes. In response, Russell has modernized the index construction rules. It should also be noted that data for the Dow Jones US Small Cap Total Stock Market Index and the CRSP US Small Cap Index is simulated prior to 2005 and 2011, respectively. At 0.24%, IWM has the highest expense ratio in the group, however, over the past year it has actually outperformed its index thanks to securities lending revenue. Also, 0.04 basis points of the expense ratio are acquired fund fees, primarily from business development companies in the index.



 

Michael Rawson, CFA is an ETF Analyst with Morningstar.
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