By
Morningstar
:
By Michael Rawson, CFA
The Russell 2000 Index is down 12% in 2011, compared with a 6%
loss for the Russell 1000. Despite that underperformance, we advise
investors to stay away from the Russell 2000. Small caps are
expensive and of lower quality, and have less exposure to
fast-growing international markets.
Valuation
Toward the end of the 1990s, large-cap stocks sold at a
price/earnings ratio of about 24 times, much higher than the
13-times valuation multiple for small caps. But since that time,
small caps have dramatically outperformed large caps, returning 4%
per year annualized compared with a flat S&P 500. While the
price/earnings ratio for large caps has fallen, it has risen for
small caps to the point that small caps now trade at a premium to
large caps. While Morningstar analysts do not cover enough
small-cap stocks to form an opinion on the valuation, the trend is
apparent: Giant caps sell at a price/fair value of about 0.78,
large caps trade at a price/fair value of about 0.82, and mid-caps
trade at about 0.90.
Quality
If we enter another recession, it is likely that more-volatile
small caps will be harder hit. About 40% of the stocks in the
Russell 2000 have negative retained earnings, compared with 30% for
the S&P SmallCap 600 Index and about 10% for the large caps in
the S&P 500. Negative retained earnings typically result after
years of losses or substantial write-offs. Morningstar's economic
moat is a measure of competitive economic advantage; while our
analysts rate just 22% of the assets in the Russell 2000 they see
moats in only 10% of the stocks, compared with 90% for the S&P
500. Small caps are also much more volatile. According to Ibbotson
data, since 1926, the volatility of large-cap stocks has been
around 20%, compared with 32% for small caps.
International Sales
While GDP growth in the U.S. has ground to a virtual standstill,
international growth, particularly in emerging markets, has trudged
forward. Additionally, U.S. exports have been one bright spot in
U.S. growth and, at nearly 14% of GDP, are at record levels. Large
caps are likelier to have the scale necessary to support
international operations, and if the dollar continues to weaken as
it has in the past decade large caps are probably better
positioned.
Among the four major index providers (Russell, S&P, Dow
Jones, and MSCI), the top-performing small-cap index returned 138%
in the past 10 years, while Russell was the worst performer,
returning only 97%. Russell does delve deeper into micro-cap
territory and has a smaller average market cap than the other three
indexes, so that could explain the difference in performance. Part
of Russell's underperformance relative to the other benchmarks can
be attributed to its own success. Because so much money is
passively tied to this index and because it follows very mechanical
and predictable construction rules and reconstitution schedules,
arbitragers front-run index changes, creating an "index drag,"
which my colleague
highlighted here
.
While Russell has introduced some changes to mitigate the impact
of index turnover, there are other issues. Another knock on Russell
has been its liberal index-inclusion rules that allow for many
nonprofitable and international companies to be included, such as
business-development corporations. Russell also had the highest
weight in financials. Small-cap banks have continued to struggle
since the financial crisis.
Depending on which definition you use, small caps typically make
up less than 10% of the equity market, so in a typical 60/40 stock
and bond portfolio, a passive allocation to small caps would only
make up about 6% of a portfolio. Given our view on small caps, we
would keep our small-cap allocation at a minimum. If we were to
pick a small-cap fund to invest in, we would probably chose either
Vanguard Small Cap (
VB
), which follows the MSCI Small Cap 1750 Index and charges just
0.17%, or iShares S&P SmallCap 600 Index (
IJR
), which charges 0.20%. Investors on the Charles Schwab brokerage
platform may prefer to use Schwab U.S. Small-Cap ETF (
SCHA
), which charges just 0.13% and follows the Dow Jones US Total
Stock Market Small Cap Index of 1,750 stocks.
As for iShares Russell 2000 (
IWM
), while we like the fact that it covers a broad swath of 2,000
companies (creating great diversification) and we like the
incredible liquidity (allowing the fund to trade at tighter bid/ask
spreads than its underlying basket), it charges 0.26% and has the
greatest exposure to a number of disadvantages affecting small
caps.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including Barclays Global Investors ((BGI)), First Trust, and
ELEMENTS, for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
See also
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