Small Cap ETFs: The First One Now Will Later Be First?

Small cap ETFs have outperformed their large cap brethren for a decade. Can the trend continue?

Some argue this outpermance trend is even older. A Fama and French study concludes that small caps outperform large caps by 4% annually, for fifty years, from 1956-2005. This long record unsettles investors weaned on the inevitability of mean reversion.

The chart below compares the benchmark small cap ETF iShares Russell 2000 Index (NYSEArca:IWM) with the large cap benchmark iShares S&P 500 Index (NYSEArca:IVV) ove the last ten years.

Over the 10-year period shown in the chart the small cap IWM has returned about 30%. An investment in IVV has declined about as much. Long-term performance will vary depending on the time period, but as the chart shows, IWM has outperformed over virtually every period. The notable exception is the 4th quarter of 2008, when the small cap IWM fell much more sharply than the large cap IVV.

Mean reversion is the idea that 'the slow one now will later be fast as the first one now will later be last' (as a rock star legend once put it). This is an important idea for investors to keep in mind, particularly those prone to chasing hot stocks, because many of these stocks cool off creating steep losses. The problem with the mean reversion argument is that sometimes the fast one stays fast and the slow one stays slow, or quits the race altogether. Also, very long term studies such as Fama and French can be difficult to assess as the very notion of small changes. Many of the small caps of the 1950s would be classified as microcaps today.

IWM has a Price to Earnings (P/E) Ratio of about 17 compared to about 14 for the large cap IVV. This suggests that investors have higher expectations for small cap companies than large cap companies.

The idea that the fast will stay fast is the substance of the argument for small cap ETFs today. Looking back a decade, small caps ETFs were priced lower than larger cap funds in terms of earnings. Today it is the reverse.

Small cap ETFs are certainly appealing. Small cap companies are typically quicker to adapt to market conditions. They are less hamstrung by bureaucracy. And small cap companies tend to be overlooked by an investment community focused on the big cap bellwethers. Small companies are often acquired, boosting their price. And perhaps most important, small cap companies can grow into big cap companies, representing opportunities for investors. Big companies -- are already big.

IVV for example holds companies like IBM ( IBM ) (otherwise known as 'Big' Blue) with a market cap in excess of 150 billion. IWM holds, what might be considered by some to be a competitor to IBM, Informatica Corporation (NasdaqGS:INFA), a data servicing provider with a market cap of 2 billion- and no moniker.

Big caps have advantages too. They are well-known brands. They are well-diversified by geography. They are diversified by business interest. They have reliable income streams and established assets. They usually have political clout, wide moats, business models with barriers to entry, and yes- fat, which can come in handy during lean times. Some of the large companies are deemed vital to the US economy, to US interests or even to functioning markets. They are thought to be too big to fail.

One measure of volatility is beta. IWM has a long-term beta of about 1.2, which means that for every point the benchmark SPY moves IWM is expected to move 1.2 points, up or down. IWM's beta over the last six months is slightly higher. Small cap beta has grown with overall market volatility. But beta does not mean outperformance. The markets' strong uptrend over the past six months mirrors a downtrend over the previous six months. On a 1-year basis, large and small cap ETFs have more similar returns.

Although they often have very similar performance, small cap ETFs are not all alike. Small cap companies lie within the 750 to 2000 US stocks ranked by size. Investors seeking exclusively small companies will want to examine IWM. Vanguard's Small-Cap ETF (NYSEArca:VB) and SPDR Dow Jones Wilshire Small Cap ETF (NYSEArca:DSC) by contrast, are broad offerings pushing into mid-cap on one end and micro-cap on the other. iShares S&P600 Small Cap Index (NYSEArca:IJR), one of the most popular small cap ETFs by volume, targets a tight band of larger-than-average small firms.

Fees for the basic small-cap ETFs range from .10% per year to .25%, with Vanguard leading. Although its net assets are smaller than some of the other funds, VB is the obvious choice for an investor with no specific index target in mind.

At first blush the SPDR and Vanguard products seem to use identical indexes. But despite both following stocks ranked 751-2500, the DJ Wilshire Small Cap Index and the MSCI US Small Cap 1750 Index commonly deviate by 1% per year. Likely causes are specific filtering methodologies which result in different industry sector weightings. A prudent course when deciding between any set of similar ETFs is to avoid those with high exposure to industries considered overvalued. We hesitate to call the MSCI index better for the long-term just because it outperforms over specific periods. Reversion to the mean will likely allow the DJ Wilshire index to catch up. Nonetheless, it remains instructive to see how indexing methodology can cause two seemingly identical ETFs to diverge by 1% per year.

Small cap indexes generally represent 8-15% of the total US stock market, so it is easy to overweight small cap. This may be a good idea when the markets are strong and investor confidence is high. When investors become risk-adverse, overweighting small cap will produce inferior returns.

All assets classes are subject to systematic market risk (broad market movement). When the market is trending lower, even the best assets are sold and fall in value. When the market is hot, ownership in even the worst-performing companies is usually profitable. So any determination of potential return must begin with an investors own sense of the overall market direction. When times are tough, investors focus on survival and all the fat of large caps is important. When investor sentiment improves, it is the reverse. Investors become less risk-adverse. They focus on growth, potential and opportunity. Small caps rule.

So, for market bulls willing to overweight small cap ETFs, the best way to limit systematic risk and leverage the volatility of this asset class is to wait for a broad market sell off or a dip to buy.

Following is a list of small cap ETFs:

Plain Vanilla Small Cap ETFs

iShares Russell 2000 Index (NYSEArca:IWM)

SPDR Dow Jones Wilshire Small Cap ETF (NYSEArca:DSC)

Vanguard Small Cap ETF (NYSEArca:VB)

Focused Small Cap ETFs

SPDR Dow Jones Wilshire Small Cap Growth ETF (NYSEArca:DSG)

SPDR Dow Jones Wilshire Small Cap Value ETF (NYSEArca:DSV)

Vanguard Small-Cap Growth ETF (NYSEArca:VBK)

Vanguard Small-Cap Value ETF (NYSEArca:VBR)

iShares Morningstar Small Growth ETF (NYSEArca:JKK)

iShares Morningstar Small Value ETF (NYSEArca:JKL)

iShares Morningstar Small Core ETF (NYSEArca:JKJ)

iShares Russell 2000 Growth ETF (NYSEArca:IWO)

iShares Russell 2000 Value ETF (NYSEArca:IWN)

iShares MSCI EAFE Small Cap Index Fund (NYSEArca:SCZ)

iShares S&P SmallCap 600 Growth Index Fund (NYSEArca:IJT)

iShares S&P SmallCap 600 Value Index Fund (NYSEArca:IJS)

Rydex S&P SmallCap 600 Pure Growth ETF (NYSEArca:RZG)

Rydex S&P SmallCap 600 Pure Value ETF (NYSEArca:RZV)

International Small Cap ETFs

SPDR Russell/Nomura Small Cap Japan ETF (NYSEArca:JSC)

SPDR S&P Emerging Markets Small Cap ETF (NYSEArca:EWX)

SPDR S&P International Small Cap ETF (NYSEArca:GWX)

WisdomTree International SmallCap Dividend Fund (NYSEArca:DLS)

WisdomTree Europe SmallCap Dividend Fund (NYSEArca:DFE)

WisdomTree Japan SmallCap Dividend Fund (NYSEArca:DFJ)

Fundamental Small Cap ETFs

(The following ETFs use fundamental financial ratios in proprietary picking formulas to try to beat the major indexes. They tend to cost .50% to 1% per year.)

Powershares Dynamic Small Cap Value Portfolio ETF (NYSEArca:PWY)

Powershares FTSE RAFI US 1500 Small-Mid Portfolio ETF (NYSEArca:PRFZ)

Powershares Zacks Small Cap Portfolio ETF (NYSEArca:PZJ)

First Trust Small Cap Core AlphaDEX Fund (NYSEArca:FYX)

FTSE RAFI Developed Markets ex-U.S. Small-Mid Portfolio ETF (NYSEArca:PDN)

PowerShares Dynamic Small Cap Growth ETF (NYSEArca:PWT)

PowerShares Dynamic Small Cap Portfolio ETF (NYSEArca:PJM)

RevenueShares Small Cap ETF (NYSEArca:RWJ)

Leveraged/Short Small Cap ETFs

(Leveraged ETFs go long or short on small caps. These are best for experienced traders. While not cheap, leveraged ETFs typically are less expensive than broker margin loans per unit of leverage.)

Rydex ExpressShares 2x Russell 2000 ETF (NYSEArca:RRY)

Rydex ExpressShares Inverse 2x Russell 2000 ETF (NYSEArca:RRZ)

ProShares Ultra Russell 2000 ETF (NYSEArca:UWM)

ProShares Ultra Russell 2000 Growth ETF (NYSEArca:UKK)

ProShares Ultra Russell 2000 Value ETF (NYSEArca:UVT)

ProShares UltraShort Russell 2000 ETF (NYSEArca:TWM)

ProShares UltraShort Russell 2000 Growth ETF (NYSEArca:SKK)

ProShares UltraShort Russell 2000 Value ETF (NYSEArca:SJH)

ProShares UltraShort SmallCap600 ETF (NYSEArca:SDD)

ProShares Short SmallCap 600 ETF (NYSEArca:SBB)

ProShares Ultra SmallCap 600 ETF (NYSEArca:SAA)

Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds .

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.

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