The Most Popular Small-Cap Index Isn’t the Best

Conventional wisdom holds that the small-cap stock arena is a more-fertile hunting ground for active managers than large-cap stocks, as smaller firms tend to be less widely followed, which makes them more likely to be mispriced. That may be true, but as the most recent installment of Morningstar's Active/Passive Barometer shows, most active managers still have a hard time beating their index counterparts.

Not all small-cap indexes are created equal. The popular Russell 2000 Index has consistently lagged other broad market-cap-weighted small-cap indexes. It isn’t a bad starting point, but there are better alternatives. Here’s a closer look at iShares Russell 2000 ETF IWM, which tracks this benchmark. This is a fine offering with a durable cost advantage against its actively managed peers, underpinning its Morningstar Analyst Rating of Bronze.

The fund employs full replication to track the Russell 2000 Index, which targets the 1,001st to 3,000th largest U.S. stocks and weights them by market capitalization. This approach effectively harnesses the market's collective wisdom and is laudably objective and transparent. As one of the oldest small-cap indexes, the Russell 2000 has become the default benchmark for many small-blend active managers. Yet, this index has been an easier benchmark to beat than many other small-cap indexes, which makes it less appealing to track. Over the trailing 10 years through June 2019, it lagged the S&P SmallCap 600 and CRSP U.S. Small Cap indexes by more than 1.5% annually.

The Russell 2000 Index's popularity can help explain its underperformance. Because there is a lot of money tied to this index, there is considerable price pressure when stocks are added to or removed from the index. Prices get bid up when new constituents are added and pushed down when stocks are removed, which can hurt the index's performance. This issue is exacerbated by the Russell 2000 Index's reach further down the market-cap ladder than some of its peers, and its smaller float requirement, which gives it greater exposure to thinly traded stocks, where the market impact cost of trading can be high.

The index does not take adequate steps to address this issue. It does not have any buffers to mitigate unnecessary turnover along its lower market-cap bound, where transaction costs tend to be the greatest. So, if a stock in the index falls even slightly below the size of the 3,000th largest U.S. stock, it gets booted from the index. And the index concentrates those changes on a single day each year, rather than gradually moving stocks in or out, which can increase price pressure. The managers of this fund have the flexibility to trade ahead of index changes to get better prices, but their primary goal is to mitigate index-tracking error.

Fundamental View Even if mispricing is more likely among small caps than large caps, broad, market-cap-weighted portfolios like this have still been tough to beat. That's because their portfolios are representative of the aggregate holdings of all active investors, yet they charge less. So, if some managers benefit from owning undervalued names, others are hurt by owning overvalued names. It's hard to consistently find bargains because market prices do a decent job reflecting public information, making it hard to gain a durable edge.

This portfolio effectively harnesses the market's collective wisdom about the relative value of each stock through its weighting approach. Market-cap weighting is also beneficial because it mitigates turnover and transaction costs. But it does have a drawback. This weighting approach increases the fund's exposure to stocks as they become larger and more expensive, and reduces its exposure to names as they become smaller and cheaper, which may have higher expected returns.

While small-cap index investing is sound, the Russell 2000 Index is not the best small-cap index around. Its popularity is part of the problem. This is one of the most widely followed U.S. small-cap indexes, which means there's a lot of buying and selling pressure when names are added to or removed from the index. This issue is exacerbated by the index's reach into micro-cap territory. The index has a smaller market-cap orientation than some of its peers, as well as lower float requirements. This gives it greater exposure to thinly traded names, where market prices have to move further to accommodate large trades. The prices of stocks that are added to the index get pushed up, while the prices of stocks slated for removal get pushed down, giving the fund less favorable prices.

Given these costs, it would behoove the index to mitigate unnecessary turnover. Yet, Russell does not apply any buffers to mitigate turnover along its lower market-cap bound, where transaction costs tend to be the greatest. The index adds and removes stocks as they barely cross its lower market-cap selection threshold. This can increase transaction costs without materially changing the portfolio's composition.

Over the trailing 15 years through June 2019, the Russell 2000 Index lagged the S&P SmallCap 600, CRSP U.S. Small Cap, MSCI USA Small Cap, and Dow Jones U.S. Small Cap indexes by at least 97 basis points annually. A regression analysis of the returns of the Russell 2000 Index revealed that it still underperformed after controlling for stylistic differences with these other small-cap indexes. This suggests that it suffered from higher transaction costs, likely owing to its popularity, considerable exposure to thinly traded micro-cap stocks, and lack of buffering rules on its lower market-cap bound.

Fees BlackRock charges an annual fee of 0.19% for this fund, which is cheap in the Morningstar Category, but there are cheaper funds available. It earns a Positive Price Pillar rating. During the trailing three years through May 2019, the fund lagged its benchmark by 1 basis point per year. The fund has been able to more than offset some of the drag created by its fee through a combination of savvy portfolio-management techniques and securities lending.

Alternatives Gold-rated Vanguard Small-Cap ETF VB (0.05% fee) is a better market-cap-weighted index alternative. Not only is it cheaper, but it will also likely face lower transaction costs. This is in part because VB has a larger market-cap orientation than IWM. But it also applies generous buffer zones to mitigate unnecessary turnover. When stocks are added to or removed from the index, it moves only half of the position at a time and it spreads those trades out over five days to reduce market-impact cost.

Like VB, Gold-rated Schwab U.S. Small-Cap ETF SCHA (0.04% fee) also climbs a bit further up the market-cap ladder than IWM and applies generous buffer rules to mitigate turnover and transaction costs. It offers a similar broad, market-cap-weighted portfolio.

Gold-rated iShares Core S&P Small-Cap ETF IJR (0.07% fee) has a similar market-cap orientation to IWM. It screens new holdings for profitability, weeding out some of the riskiest small-cap names. The index this fund tracks is managed by a committee that strives to accurately represent the small-cap market while limiting unnecessary turnover.

IShares Edge MSCI Multifactor USA Small-Cap ETF SMLF (0.30% expense ratio) may also be worth considering. This fund targets U.S. small-cap stocks with the most attractive combination of value, momentum, quality, and small-size characteristics, which have each historically been associated with market-beating performance.

Disclosure: Morningstar, Inc. 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.