Is the Deck Stacked Against Your Small-Cap Index Fund?

The Russell 2000 Index is down 12% in 2011, compared with a 6% loss for the Russell 1000. Despite that underperformance, we advise investors to stay away from the Russell 2000. Small caps are expensive and of lower quality, and have less exposure to fast-growing international markets.

Valuation
Toward the end of the 1990s, large-cap stocks sold at a price/earnings ratio of about 24 times, much higher than the 13-times valuation multiple for small caps. But since that time, small caps have dramatically outperformed large caps, returning 4% per year annualized compared with a flat S&P 500. While the price/earnings ratio for large caps has fallen, it has risen for small caps to the point that small caps now trade at a premium to large caps. While Morningstar analysts do not cover enough small-cap stocks to form an opinion on the valuation, the trend is apparent: Giant caps sell at a price/fair value of about 0.78, large caps trade at a price/fair value of about 0.82, and mid-caps trade at about 0.90.

Quality
If we enter another recession, it is likely that more-volatile small caps will be harder hit. About 40% of the stocks in the Russell 2000 have negative retained earnings, compared with 30% for the S&P SmallCap 600 Index and about 10% for the large caps in the S&P 500. Negative retained earnings typically result after years of losses or substantial write-offs. Morningstar's economic moat is a measure of competitive economic advantage; while our analysts rate just 22% of the assets in the Russell 2000 they see moats in only 10% of the stocks, compared with 90% for the S&P 500. Small caps are also much more volatile. According to Ibbotson data, since 1926, the volatility of large-cap stocks has been around 20%, compared with 32% for small caps.

International Sales
While GDP growth in the U.S. has ground to a virtual standstill, international growth, particularly in emerging markets, has trudged forward. Additionally, U.S. exports have been one bright spot in U.S. growth and, at nearly 14% of GDP, are at record levels. Large caps are likelier to have the scale necessary to support international operations, and if the dollar continues to weaken as it has in the past decade large caps are probably better positioned.

Among the four major index providers (Russell, S&P, Dow Jones, and MSCI), the top-performing small-cap index returned 138% in the past 10 years, while Russell was the worst performer, returning only 97%. Russell does delve deeper into micro-cap territory and has a smaller average market cap than the other three indexes, so that could explain the difference in performance. Part of Russell's underperformance relative to the other benchmarks can be attributed to its own success. Because so much money is passively tied to this index and because it follows very mechanical and predictable construction rules and reconstitution schedules, arbitragers front-run index changes, creating an "index drag," which my colleague highlighted here.

While Russell has introduced some changes to mitigate the impact of index turnover, there are other issues. Another knock on Russell has been its liberal index-inclusion rules that allow for many nonprofitable and international companies to be included, such as business-development corporations. Russell also had the highest weight in financials. Small-cap banks have continued to struggle since the financial crisis.

Depending on which definition you use, small caps typically make up less than 10% of the equity market, so in a typical 60/40 stock and bond portfolio, a passive allocation to small caps would only make up about 6% of a portfolio. Given our view on small caps, we would keep our small-cap allocation at a minimum. If we were to pick a small-cap fund to invest in, we would probably chose either  Vanguard Small Cap (VB), which follows the MSCI Small Cap 1750 Index and charges just 0.17%, or iShares S&P SmallCap 600 Index (IJR), which charges 0.20%. Investors on the Charles Schwab brokerage platform may prefer to use Schwab U.S. Small-Cap ETF (SCHA), which charges just 0.13% and follows the Dow Jones US Total Stock Market Small Cap Index of 1,750 stocks.

As for iShares Russell 2000 (IWM), while we like the fact that it covers a broad swath of 2,000 companies (creating great diversification) and we like the incredible liquidity (allowing the fund to trade at tighter bid/ask spreads than its underlying basket), it charges 0.26% and has the greatest exposure to a number of disadvantages affecting small caps.