Small-Cap Indexing: Popularity Can Be a Pain

The Russell 2000 Index is the most popular benchmark for active small-cap managers to measure themselves against. But here is an industry secret: Active managers pick that index because it is easy to beat. If you're going with a passive strategy, you don't have to limit yourself to that index.

Among small-cap exchange-traded funds,

U.S. small caps have historically provided some diversification benefits. The Russell 2000 Index had a correlation of around 0.92 with the S&P 500 during the past 10 years. That said, small-cap stocks tend to be riskier as they exhibit greater sensitivity to macroeconomic risks and typically lack economic moats--or sustainable competitive advantages. The greater risk in small-cap stocks is evident in their volatility. During the past 10 years, the standard deviation of monthly returns of the Russell 2000 Index was 20%, more than 5 percentage points greater than that of large-cap equities, as represented by the S&P 500.

For passive investors, obtaining small-cap exposure by holding a broad or total stock market fund is more tax-efficient than holding separate funds to cover each size segment because a total stock market fund requires lower turnover. Consequently, it may be more efficient for investors to get the bulk of their exposure to small-cap stocks through a total market fund and then use a smaller position in a small-cap fund for tactical purposes.

Small-cap stocks have earned a return premium of about 2% over large-cap stocks since 1926. However, this premium has become smaller in recent decades. From 1979 through 2014, the large-cap Russell 1000 slightly outpaced the small-cap Russell 2000 Index. The small-cap premium can also vary drastically over time. For example, during the entire decade of the 1990s, small-cap stocks underperformed large caps by 3% per year.

While the small-cap premium may be unreliable, it has been positive during the past 15 years, as small-cap stocks have been on a tear since the tech bubble burst. This stretch of outperformance has caused small caps to look expensive relative to large caps. Back in the tech bubble of the late 1990s, large caps traded at a premium relative to small caps. But this situation has reversed, and small caps now command a premium valuation. For example, in 2000, large-cap stocks in the S&P 500 traded at a price/projected earnings ratio of around 27 compared with 14 for the small-cap stocks in the Russell Index. Currently, large caps trade at a price/projected earnings ratio of around 18, while small caps trade at a multiple of about 19 times prospective earnings.

In addition to being more expensive, smaller-cap stocks often lack Morningstar Economic Moat Ratings, or sustainable competitive advantages. Consequently, they tend to be less profitable and less resilient in the face of economic turbulence. Stocks in the large-cap S&P 500 generated a return on invested capital of 15% during the past year, while the corresponding figure for those in the Russell 2000 Index was only 2%. Rich valuations and pronounced vulnerability to rocky economic conditions are good reasons to not give an overweighting to small caps at this time. These stocks make up a small portion of the U.S. equity market.

Because of its popularity, the Russell 2000 Index is more susceptible to front-running by arbitragers seeking to exploit index changes than are other small-cap indexes. When these arbitragers trade ahead of the index, they can hurt the index's performance by pushing up the prices of the stocks that it is set to add and by depressing the prices of the stocks that it is slated to trim, as my colleague Alex Bryan discussed. Investors may be better-served in an index fund that tracks a less popular small-cap index, such as the S&P SmallCap 600 Index or CRSP U.S. Small Cap Index.

This fund tracks the Russell 2000 Index, which represents about 8% of the U.S. equity universe and consists of the smallest 2,000 companies in the broader Russell 3000 Index. The average market cap of the index's constituents is $1.5 billion, compared with $70 billion in the S&P 500. With a market-cap-weighted large-cap index fund, a few mega-cap stocks have an outsized impact on the performance of the portfolio. The top 10 holdings in IWM account for just 3% of assets, compared with 17% for the S&P 500. While both indexes are market-cap-weighted, the exclusion of mega-cap stocks results in a much smoother distribution of assets in a small-cap index. The index reconstitutes annually, although eligible initial public offerings are added quarterly. The mechanical index-inclusion rules followed by Russell lead to an unbiased portfolio that casts a wide net, capturing almost all small-cap stocks, but it can result in the inclusion of less-profitable companies. For example, stocks representing about 38% of the value of the Russell 2000 have negative retained earnings, compared with 18% for the S&P SmallCap 600 Index. Relative to index funds offering exposure to U.S. large caps, this fund has larger weightings in business services and financials, while providing less exposure to the energy and media sectors. The fund follows a full replication strategy, holding nearly every stock in the index.

The fund charges an expense ratio of 0.20%. While this expense is less than that charged by most small-cap mutual funds, there are cheaper index alternatives. In practice, this fund has an extremely low estimated holding cost and has trailed its index by just 5 basis points during the past year through January 2015. Small-cap exchange-traded funds are often able to offset costs through the use of securities lending. In the case of IWM, the advisor keeps 30% of securities lending income and gives the remaining 70% to the fund. The 2014 annual report showed that about 17% of the portfolio was out on loan and that it generated $45.6 million in securities-lending income. As the most popular small-cap ETF, this fund's vast liquidity can make it cheap to trade.

There are cheaper small-cap ETFs available with adequate trading volume for all but the largest trades.

Investors who are looking for purer exposure to micro-cap stocks and who can handle the extra risk might consider

Investors just looking to complement a position in large-cap stocks with smaller-cap stocks might consider

Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.