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ETF Specialist

A Small-Cap ETF With a Leg Up

This exchange-traded fund's efficient, market-cap-weighted construction and low fee put it in a strong position to outperform its small-cap peers.

High transaction costs can hurt the performance of small-cap index funds if they track a poorly constructed index. For example, the Russell 2000 Index is the most popular U.S. small-cap stock index, but it wasn't originally built to be investable. Its popularity puts it at a disadvantage to other small-cap indexes because there is a large amount of money tied to it. When the Russell 2000 Index adds or removes stocks, heaps of money move into or out of what are often thinly traded names, which can move prices and hurt performance. This primarily affects the index's lower market-cap bound, exacerbated by the fact that the index delves further down the market-cap spectrum than most of its peers, where the market-impact cost of trading is greater. And the index doesn't use buffering rules to mitigate transactions around its lower bound.

Funds like  iShares Core S&P Small-Cap ETF (IJR) should have a leg up over those that track the Russell 2000 Index, because it tracks the less popular S&P SmallCap 600 Index and uses buffering rules to mitigate turnover when it doesn't materially affect the portfolio's composition. This is a well-diversified small-cap index that accurately represents its peers' opportunity set. The fund's low fee and efficient portfolio construction keep transaction costs down and support its Morningstar Analyst Rating of Gold.

A committee selects the final holdings of the S&P SmallCap 600 Index, so it doesn't follow mechanical rules or a strict reconstitution schedule like many of its index peers. This structure favors flexibility over transparency. The index also avoids recent IPOs and considers only profitable stocks for inclusion, which gives the fund a stronger quality orientation than the broader Russell 2000 Index. Most small-cap stocks haven't established durable competitive advantages and tend to be riskier than their large-cap counterparts, but small-cap stocks may also offer higher returns. The fund's stringent inclusion criteria help it avoid the riskiest small-cap names, and its broad, market-cap-weighted portfolio effectively diversifies firm-specific risk.

On top of its efficient market-cap-weighted construction, the fund has several advantages that mitigate transaction costs. First, it tracks an index less popular than the Russell 2000 Index so there's less demand for liquidity when it reconstitutes. Second, the index requires that at least 50% of a stock's shares trade in the market, which removes less-liquid names. These liquidity hurdles help lower the fund's transaction costs. Its average 10-year turnover of 16% through 2017 measures less than a fourth of the small-blend Morningstar Category average.

During the past decade through June 2018, the fund beat the category average by 3.3 percentage points annually with similar risk. Much of this relative outperformance can be attributed to the fund's cost advantage. Because this index fund is always fully invested, it suffered a larger drawdown than the category average during the financial crisis. But its smaller cash drag pays off during bull markets.

Fundamental View
Broadly diversified, market-cap-weighted index funds such as this one realize a sustainable advantage over most peers from efficient portfolio construction. The fund's broad, market-cap-weighted portfolio accurately represents its peers' opportunity set. Stock prices, which dictate the fund's weightings, quickly absorb new information and reflect the collective wisdom of the market (or madness of the crowd).

While market participants have done a good job of valuing stocks over the long term, the market has gone through episodes of mania and panic. But this risk is a small price to pay for the cost advantage gained from market-cap-weighting. Market-cap-weighted index funds are cheaper to run than most actively managed funds because they require fewer investment personnel. If the fund sponsor passes on the economies of scale to fundholders through lower fees (as this fund does), then investors benefit from a low fee hurdle to clear each year.

The index this fund tracks, the S&P SmallCap 600 Index, enhances the efficiency of market-cap-weighting to keep ownership costs down. As mentioned above, the index is not as popular and has more-stringent inclusion criteria than peer small-cap indexes. It requires new additions to be profitable and has higher free-float and trading volume requirements than its peers. These requirements help the index keep trading costs down by filtering out risky, thinly traded stocks, which are expensive to trade. Finally, the index committee uses its discretion to avoid swapping out holdings when they don't significantly affect the portfolio's style characteristics.

Small-cap stocks tend to be riskier and less profitable than large-cap stocks because they have less established competitive advantages and they're more sensitive to the business cycle. But they offer diversification benefits and may compensate investors with higher returns. Over the very long term, small-cap stocks have generated higher returns than large-cap names, but they can experience decade-long stretches of underperformance.

The index's initial profitability screen may improve returns. In a paper titled "Size Matters, If You Control Your Junk," AQR's research team found that removing less-profitable small-cap stocks increased the returns of small-cap stocks relative to large caps. The fund doesn't add unprofitable stocks or recent IPOs, but it can hold stocks that have become unprofitable. The fund's quality tilt helps performance in down markets. Its 10-year downside capture ratio measures 90.6 relative to the Russell 2000 Index. This means that during down markets, this fund's drawdowns measured about 10 percentage points less than the category index.

The fund's initial profitability screen shifts sector weightings away from the Russell 2000 Index. It has less exposure to financial and real estate sector stocks. Not surprisingly, the fund holds barely any biotech stocks. Conversely, its industrials sector weighting is higher than the category average. Market-cap-weighted index funds carry low cash balances that help performance during bull markets but detract during bear markets.

Portfolio Construction
This fund uses full replication to track the S&P SmallCap 600 Index. This index effectively diversifies risk, promotes low turnover, and accurately represents its target market segment. It earns a Positive Process rating.

A committee selects the names for the S&P SmallCap 600 Index, which offers some discretion in its selection process compared with indexes that follow rigid selection criteria. New additions must have been profitable in the most recent quarter and over the prior four quarters to be added to the index. Stocks must also have market caps between $450 million and $2.1 billion to be added. These ranges are updated as necessary to maintain a small-cap orientation.

The S&P SmallCap 600 Index has higher free-float and trading volume requirements than its small-cap index peers, which help it avoid the least-liquid stocks that tend to be expensive to trade. The index committee does not follow a set reconstitution schedule, so it can be difficult to anticipate changes ahead of time. The index rebalances quarterly on the third Friday in the last month of the quarter. The portfolio managers use dividend reinvesting and derivatives to keep pace with the benchmark. The fund has historically used securities-lending revenue to offset expenses.

The fund's 0.07% annual fee is among the lowest in its category, supporting its Positive Price Pillar rating.

The fund's expense ratio is a fraction of the 1.03% median levy that its category peers charge. During the trailing three years through June 2018, the fund lagged its benchmark by 3 basis points per year. This implies the fund has been able to offset some of the drag created by its fee through a combination of savvy portfolio management techniques and securities lending.

Investors looking for a dedicated U.S. small-cap index fund have several attractive options to choose from, including  Vanguard Small-Cap ETF (VB) (0.05% expense ratio) and  Schwab U.S. Small-Cap ETF (SCHA) (0.05% expense ratio). Both funds have larger average market caps and hold more than twice the amount of stocks that IJR holds. IJR's index is run by a committee that strives to balance accurately representing the small-cap market while limiting turnover. VB and SCHA keep turnover down by employing generous buffering rules. Both funds earn Analyst Ratings of Gold.

Bronze-rated  Vanguard Russell 2000 ETF (VTWO) (0.15% expense ratio) holds more than 3 times the number of stocks as VB, but its average market cap is similar. VTWO tracks the Russell 2000 Index, which doesn't use buffer rules around its lower market-cap bound. And because the Russell 2000 Index has more money tied to it and dips into less liquid securities, it can incur greater transaction costs than IJR.

Gold-rated  DFA U.S. Small Cap  (DFSTX) (0.37% expense ratio) doesn't track an index, but it is a market-cap-weighted fund that invests in small-cap U.S. stocks that systematically avoids the most-expensive and least-profitable names in this market segment. The portfolio managers take a patient approach to trading to minimize transaction costs, which is especially important in the less liquid small-cap space. This fund's average market cap is similar to IJR's, but DFSTX holds nearly 3 times the number of stocks that IJR holds.


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Adam McCullough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.