McCall's Call: The ‘ABCs’ Of Size And Style

The growth of exchange-traded funds has created opportunities for investors that weren't available in the past, and yet many people aren't taking advantage of all the options now available to them in terms of size and style in stock investing.

Matthew D. McCall

For those interested in hedge-fund replication strategies, a
number of ETFs are on the market to help calm investors’ nerves
and lower daily price swings. So, I want to focus on those,
including those that soften the blow of volatility by going both
long and short.

Indeed, the majority of investors continue to opt for a passive approach to investing by simply buying into an ETF that tracks a major index such as the S&P 500.

This strategy would have worked well if you were lucky enough to buy into the SPDR S&P 500 ETF (NYSEArca:SPY) in March 2009. But even though SPY has almost doubled since the market March 6 low that year, it lags many of its closest competitors. A quick review of size and style is in order.

The universe of stocks in the U.S. can be categorized in a number of ways. One is by market capitalization-the market value of the company based on multiplying share price by the number of outstanding shares. The three categories are large-cap (over $10 billion), midcap ($1 billion to $10 billion) and small-cap ($100 million to $1 billion).

From there, size can be split into style categories that include growth, value and core. Core is a mix of stocks that exhibit both average growth and value characteristics. Stocks in the growth class exhibit above-average growth as compared to their peers, while value stocks are considered inexpensive relative to fundamental comparisons.

To parse differences in returns, I looked at nine ETFs offered by iShares that cover all the sizes and styles I mentioned above. I compared the ETFs against each other during various time frames dating back to the S&P 500's all-time high on Oct. 11, 2007.

I won't mention all of them by name here, but you can compare all their returns on the table at the bottom of this story.

Smaller Is Better During A Bull Market

Stocks recently marked the two-year anniversary of a bull market that began in March 2009. From the bottom through the end of February of this year, the S&P 500 rose by an astounding 94 percent.

But of the nine ETFs I looked at, the best performer during that period gained 174 percent, and the worst of the group returned 78 percent. All three of the large-cap ETFs separated by style-value, core and growth-lagged the return of the S&P 500, while the worst of the small- and midcap ETFs returned a minimum of 130 percent.

During bull markets, investors typically become less risk averse and therefore are willing to take their chances on more aggressive styles by choosing growth stocks over slower-moving large-cap value options. Indeed, the iShares Morningstar Large-Cap Value ETF (NYSEArca:JKF) was the laggard, with a gain of 77 percent, while the iShares Morningstar Large-Cap Growth ETF (NYSEArca:JKE) gained 90 percent.

Just as investors often choose growth stocks in the large-cap category during bull markets, some will take the next step to take more risk on a small-cap ETF, versus a large-cap fund.

This tendency is clear in the returns I looked at, with the iShares Morningstar Small-Cap Growth ETF (NYSEArca:JKK) gaining 140 percent.

Oddly enough, the best performer during the two-year bull market has been the iShares Morningstar Small-Cap Value Index Fund (NYSEArca:JKL), which gained 174 percent. An explanation for this might be that a large number of once-high-growth stocks fell so much during the market crash that they essentially became value plays.

Go Big When The Bear Shows Up

During bear markets-in particular the one that began in October 2007 and ended on March 6, 2009-large-cap ETFs will outperform due to risk aversion. The best-performing ETF during the bear market was large-cap growth, JKE, which declined 51 percent-a bit less than the S&P 500, which lost 56 percent.

The worst-performing ETFs were the small-cap value fund (NYSE Arca:JKL), and the midcap value fund (NYSEArca:JKI), which is somewhat surprising. I would have thought that the biggest losers would have been growth stocks within the same asset classes, not value.

The Tale Of The Tape

When it comes down to investing for the long term, we must all realize there will be both bull and bear markets. And, the probability of success increases greatly by investing in ETFs that can outperform through the peaks and troughs.

This leads to my final analysis of performance from the peak of the S&P 500 in the fall of 2007 through the end of February 2011. This includes, as we all know too well, a nasty bear market and, lest we forget, one of the most robust bull markets in the history of stocks.

As a gauge, I'll use the S&P 500, which is around 15 percent below the high it reached in mid-2007-not bad when considering what has taken place over the last three years.

You could have done much worse-or better-depending on which of the nine ETFs you selected to invest in. All three small-cap ETFs generated positive returns of at least 5 percent, with the small-cap value fund, JKL, leading the way with a 7 percent gain.

The large-cap ETFs were the clear laggards, with the large-cap value fund, JKF, down more than 28 percent. The performance gap of 35 percent between JKF and JKL over about 40 months is dramatic. When annualized, that's a difference of about 11 percent per year. To be clear, the 40 months I'm referring to span the time frame from the market high in 2007 to the end of February.

2011 And Beyond

Now that I've shared all the past-performance numbers, I'll leave you with a prediction for the future:I believe investors will continue to lean toward the high-growth and small-cap ETFs as overall tolerance for risk remains above normal.

That said, the moment the market begins to lose steam and investors look to mitigate risk, the large-cap and value ETFs should once again take over the leadership role.

ETF Symbol 3/6/09-2/28/11Bull Market 10/11/07-3/6/09Bear Market 10/11/07-2/28/11
iShares Morningstar Large Core JKD 85.7% -52.0% -10.8%
iShares Morningstar Large Value JKF 77.7% -59.7% -28.4%
iShares Morningstar Large Growth JKE 90.4% -51.3% -7.3%
iShares Morningstar Mid Core JKG 135.6% -57.7% -0.4%
iShares Morningstar Mid Value JKI 148.4% -63.2% -8.5%
iShares Morningstar Mid Growth JKH 130.8% -56.6% 0.1%
iShares Morningstar Small Core JKJ 156.4% -58.9% 5.3%
iShares Morningstar Small Value JKL 174.1% -61.0% 7.0%
iShares Morningstar Small Growth JKK 139.8% -56.6% 4.0%
S&P 500 Index 94.2% -56.0% -14.6%

Matthew D. McCall is editor of The ETF Bulletin andpresident of Penn Financial Group LLC, a New York-based wealth management firm specializing in investment strategies using ETFs.

Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2011 Index Publications LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


More Related Articles

Sign up for Smart Investing to get the latest news, strategies and tips to help you invest smarter.