The four largest small-blend exchange-traded funds each have something to offer passive investors looking to overweight small-cap stocks.
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
iShares Russell 2000 Index
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.