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.
Adam McCullough, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.