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3 Gold-Rated Small-Cap Index Funds

Adam McCullough, CFA
Susan Dziubinski

Susan Dziubinski: Small-cap stocks have plenty going for them. They can add diversification to a portfolio and offer greater potential return than large-cap stocks albeit with some additional risk. Here to discuss the three highest-rated small-cap ETFs that Morningstar analysts cover is Adam McCullough. He is an analyst in our manager research group focusing on passive strategies.

Adam, thank you for joining us today.

Adam McCullough: Happy to be here today, Susan.

Dziubinski: Now, all three of the funds that we are going to talk about today track well-constructed investable indexes, and they are inexpensive to boot. The three funds do have some differences. The first one is Schwab U.S. Small-Cap ETF.

McCullough: You are right, Susan. Each of these funds do something a little bit different to dampen the impact of trading costs among the small-cap indexes. The first fund is Schwab U.S. Small-Cap ETF. What this fund does, it tracks one of the Dow Jones small-cap indexes, and it uses buffering rules so that it doesn't trade stocks unnecessarily on its reconstitution dates. If a stock graduates to the mid-cap level, it won't trade it into the mid-cap, then out of the mid-cap, then into the mid-cap if it's on the edge. It will wait until it's fully in that mid-cap range before trading. 

You get the exposure that you want in small-cap stocks without unnecessarily trading names as they go between different buckets. And so, this fund also charges 5 basis points per year, so it's cheap. Over the past three years through December 2018, it's actually outpaced its benchmark by 2 basis points per year. That kind of shows, one, that it's mitigating the impact of transaction costs, and two, might have some help with securities-lending income that offsets some of the fees that it charges.

Dziubinski: Another one of our Gold-rated ETFs is Vanguard Small-Cap ETF. How is this one a little bit different?

McCullough: The Vanguard fund is a little bit different in that it tracks the CRSP Small Cap Index. So, again, it's looking for small-cap stocks. But the CRSP indexes were built to be investable. Maybe the first generation of indexes were more benchmarks, you know, how is your fund performing. The CRSP suite of indexes is made for investment. What this fund does beyond buffering rules is it actually will spread out trading over five days. So, when the mix changes, instead of trading all the stocks on one day-so buying a bunch of names, selling a bunch of names--it trades that over five days in a week. That will break the impact of the trades by one-fifth because it's trading one over five days.

And the second thing that it does is it uses a technique called packeting. What this means is, when a stock graduates to the mid-cap bucket, instead of moving everything at once, once it does get fully into that bucket, it will move half of the position. It will move half the position, wait till the next reconstitution; if the stock is still squarely in the mid-cap range, it will move the other half. So, that also breaks the trading in half and so it lowers the market impact cost as well. This fund is rated Gold as you mentioned. It charges 5 basis points per year. Over the past three years through December 2018, it's also topped its benchmark by 2 basis points.

Dziubinski: And our last Gold-rated small-cap ETF is iShares Core S&P Small-Cap ETF. And this one has a market cap that seems to fall somewhere between the other two funds that we've talked about so far.

McCullough: That's right. The iShares Core S&P Small-Cap ETF does fall between those other two funds based on its average market cap. But this fund also uses a little different of a technique to avoid forecasting its trades in the market. While the first two funds follow strict reconstitution schedules, the S&P Small Cap 600 Index is actually run by a committee. It doesn't have a prescheduled reconstitution day and the committee members can actually decide when to add or remove names from the index. You can't forecast out, this is the June reconstitution; it looks like these stocks might graduate to the mid-cap index and will be sold out of this index. They can say, you know what, now it's time to reconstitute, we're going to go ahead and do that. And so, by not forecasting the trades, it lowers the transaction costs for funds such as this fund that track the index. 

And this fund is also cheap. It charges 7 basis points per year. It's actually not outpaced its index, unlike the other two funds. It's lagged by 1 basis point over three years, but still very small.

Dziubinski: These all sound like great options for investors. Adam, thank you for your insights today.

McCullough: Absolutely.

Dziubinski: I'm Susan Dziubinski for Morningstar.com. Thank you for watching.