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By Christine Benz and Ben Johnson, CFA | 10-10-2017 12:00 AM

2 ETF Picks to Harness the Small-Cap Effect

Relative to benchmarks, the small-cap effect really has failed to materialize, says Ben Johnson.

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Does the so called small-cap effect hold up to further scrutiny? Joining me to share some research on this topic is Ben Johnson, he's director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me.

Benz: Ben a lot of investors have heard about this small-cap effect, the idea that small caps would outperform the broad market on a risk-adjusted basis. Let's talk about where that idea initially came from.

Johnson: The small firm effect was first documented by Rolf Banz in his 1981 Ph.D. thesis, in which he showed that small-cap stocks, those occupying the very bottom rungs of the market capitalization ladder, tended to, on average, outperform on a risk-adjusted basis their larger cap peers. Now, this made sense, there is some intuition behind this, just given that smaller firms would, in theory, tend to be a bit more risky, relative to large-cap stocks. The business is less mature, it's less entrenched, these are smaller firms with smaller balance sheets. They might have a more concentrated clientele. There are any number of different reasons why they might be riskier, and the intuition in traditional finance being that risk must come with some sort of compensation. So that these returns that would exceed those of large-cap stocks would be exactly that. They would be that carrot to take on that additional risk by investing in smaller firms.

Benz: You wrote in the piece that there are good intuitive reasons to believe this might the case. One you pointed out was that just in terms of analyst research they tend to be less followed than some of the very large-cap companies. It kind of makes sense that better returns might follow for people who are willing to roll up their sleeves and do some research.

Johnson: Absolutely. These other institutional effects in place, too, as you mentioned, there might be just informational barriers. Investors might have a tougher time getting access to information about smaller firms. They might be under followed by analysts. Also, they tend to be much less liquid than larger cap stock. There might be some sort of liquidity premium, again in the form of compensation, for taking on the risk of illiquidity and some sort of market event that would further incentivize investors to invest in small-cap names.

Benz: In ETFInvestor in the most recent issue, in the September issue, you took stock at the research that has subsequently kind of poked at the small-cap effect, attempted to see whether it actually will hold up going forward or has even held up in the past. Let's talk about that.

Johnson: Subsequent to Banz's publication of his Ph.D. thesis, we have seen a number of holes poked in the argument that small caps should writ large produce superior risk-adjusted returns. Part of this has to do with the fact that the small-cap effect tends to be concentrated in the very smallest of the small-cap names, microcaps. Most of that boost that that whole cohort is getting is from the very riskiest of risky names, these are lottery ticket-type stocks. The other phenomenon that was discovered subsequently was that the small firm effect at least historically had been concentrated in the month of January, and half of that effect that took place in January was focused on the first five trading days of the year.

Now any sort of calendar-year basis or event-driven intuition as a justification, the foundation for real legitimate risk premia is somewhat shaky. What you've also seen over time is that the small-cap effect empirically has apparently just diminished if not disappeared entirely. You see that, in the relative performance since the early 1980s of the Russell 1000 benchmark, which encompasses large- and mid-cap stocks versus the Russell 2000 benchmark, which is one of the most widely followed indexes of small-cap stocks, what you've seen is that from the point of view of those two benchmarks, the small-cap effect really has failed to materialize in any sort of significant investible way.

Benz: Let's discuss index construction, and you and the team focus a lot on this issue of how ETFs that track indexes, how those indexes come together. Let's talk about how firms have tried to approach the small-cap universe and in some cases constructed indexes that attempt to address some of these data shortcomings.

Johnson: It's important to understand index construction when it comes to investing in index mutual funds and ETFs. When it comes to looking at small-cap funds there are no exception. What you see is that depending on the index family involved, their definition of small caps could capture anywhere from about 3% to about 13% of the overall market capitalization of the U.S. market. Could be the smallest of the small, it could be small-cap names bleeding into mid-cap names. It's important to understand especially from a portfolio construction perspective, what is the definition of small in question here, and is there the risk that I might be creating some redundancies, some overlap in adding a small-cap index fund within the context of my portfolio where I might have pre-existing exposures to especially some mid-cap names. Understanding the beginning universe, the particulars of the market-cap spectrum or the portion of the market-cap spectrum that that index captures is absolutely critical when it comes to portfolio construction.

Benz: Look at what you already own, look at how much of the style box your existing exposure covers, and then kind of use the small-cap fund as a building block to slot in there alongside your other exposures?

Johnson: Absolutely.

Benz: OK.

Johnson: Absolutely. And furthermore, it's important to understand some of the other criteria that are informing the index methodology. Most notably in the small-cap space, it's important to understand whether or not there are any screens, any potential sort of constraints with respect to liquidity and how also rebalancing the portfolio is handled. If you look at for example the S&P 600 SmallCap Index, what that index does, which is distinct from its peers, is it screens potential stocks to be included in the portfolio for profitability. It effectively acts as a quality screen. What you see is that when you screen small caps for quality, screening out the junkier names, keeping only the higher quality names, those that tend to be more profitable, have sounder balance sheets, is that all of a sudden you almost breathe the small-cap premium back to life. It reappears by getting rid of sort of long left tail of junky stocks.

It's also important to understand as I mentioned before how the portfolio, how the index handles turnover. If you look at the Russell 2000 index for example it has no real buffer at the bottom end of the index to mitigate unnecessary turnover, to prevent names from being dropped prematurely or being added prematurely. What you see is that that been a material hindrance, a material headwind to that index because there is a cost involved in regularly adding and deleting names from that portfolio, especially given that it's a widely followed by such a huge number, of not just index funds and ETFs, but opportunistic investors that try to exploit the potential pop that you might get from a stock that would be added to that index, and to get away from or otherwise short those stocks that might be dropped from that index.

Benz: Let's talk about some specific ETFs that you and the team like that you think embody some of these characteristics that we’ve talked about.

Johnson: Our two most highly rated small-cap U.S. equity ETFs are the Vanguard Small-Cap ETF, VB, and the iShares Core S&P Small Cap ETF, IJR. We've awarded both of these funds Morningstar Analyst Ratings of Gold, which indicates that we believe that these ETFs will produce superior risk-adjusted returns relative to their peers in the small-blend category over a full market cycle. We have that degree of conviction chiefly because these funds charge rock-bottom fees--that is their most sustainable competitive advantage relative to the rest of the cohort.

Furthermore, we like the way that the underlying benchmarks are built. In the case of the Vanguard fund it tracks the CRSP U.S. Small Cap Index, which is a broad-based market-cap-weighted slice of the smallest segment of the U.S. stock market. It has sensible rules in place to mitigate unnecessary turnover within the portfolio, these are all things that score highly in our view. In the case of the iShares fund, it tracks the aforementioned S&P 600 SmallCap Index, which as I alluded to has certain quality criteria whereby it screens out junkier stocks from the portfolio. It, like it's Vanguard competitor, has a rock,bottom fee and we have a high degree of conviction that this is going to deliver top-notch outcomes for investors over a full market cycle.

Benz: Last question for you, Ben. I know you and the team keep tabs on what you call the active-passive barometer. In the small cap space some investors might be operating with the conventional wisdom the small caps are an area where you want to use an active manager. Does that hold up to further scrutiny?

Johnson: What we see in the results of our active-passive barometer are that relative to large-cap managers and even mid-cap managers, small-cap managers, active security selectors in the small-cap space, have had better odds of beating their benchmark--in our case our benchmark is a composite of all of the index funds and ETFs in a given category--but they are still inferior to a coin flip. Now how can investors improve those odds? What we've seen is if you look at the results, the success rates of active managers by fee quartile, what we've seen is that over various time frames the lowest cost contingent in any given category has above average odds of beating their passive peers over a long period of time in particular. For investors who believe that small caps are inherently less efficient, for investors who believe their odds, and our data would corroborate this, are better with active managers in the small-cap space, they are going to be better still if they focus on a narrower subset of the lowest cost active funds in that category.

Benz: OK, great. Whether you are seeking in active fund or some sort of passive vehicle to costs are ultracrucial.

Johnson: Costs matter.

Benz: Ben thank you so much for being here.

Johnson: Thank you.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.

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