Big Differences Between Some Small-Cap ETFs

The Russell 2000 and the S&P SmallCap 600 Indexes are the benchmarks of benchmarks when it comes to smaller U.S. stocks. There are plenty of exchange-traded funds linked to those indexes, but for the purposes of this piece, we'll use the iShares Russell 2000 Index (ETF) IWM, the largest small-cap ETF, and the iShares S&P SmallCap 600 Index (ETF) IJR.

As their names imply the Russell 2000 and the S&P SmallCap 600 Indexes hold about 2,000 and 600 stocks, respectively. With such a wide discrepancy in the number of holdings it is reasonable to expect, particularly over longer holding periods, that these small-cap benchmarks will produce returns that are nowhere close to each other.

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To be precise, IWM currently holds 1,945 stocks while IJR is home to 600 small caps, according to iShares data.

However, there are other differences investors should be aware of.

More Differences

“Constituents in IWM but not in IJR include firms with market caps above the largest firms in IJR — in fact, IWM has 23 percent overlap with the SPDR S&P MidCap 400 ETF MDY — as well as firms smaller than the smallest in IJR, or what many might call microcaps. In the end, however, the weighted average market cap of stocks in IWM is only slightly larger than those in IJR, at $1.9 billion versus $1.5 billion, respectively,” said AltaVista Research in a research note.

Based on the premise that larger stocks are historically less volatile than their smaller counterparts, it would be reasonable to expect that IWM, with more mid-cap exposure than IJR, would also be less volatile. However, perhaps by virtue of its micro-cap exposure, IWM has been 80 basis points more volatile than IJR over the past three years.

With such a big difference in number of holdings, it is also reasonable to expect some significant sector-level differences with IWM and IJR. For example, IWM's top three sector weights are financial services, technology and healthcare. In the small-cap world, healthcare often means biotech and that is a contributing factor to IWM's volatility. Those sectors combine for 55.1 percent of IWM's weight.

IJR's top three sectors weights, in order, are financials, industrials and technology. Those groups combine for about 57 percent of the ETF's lineup. Additionally, IJR's financial services and technology allocations are below those of IWM. Likewise, IJR's healthcare weight is 160 basis points below that of IWM.

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“If size and sector allocations are similar, what accounts for such differences in performance? The answer is fundamentals. Whereas Russell’s index methodology simply ranks all U.S. stocks by size and groups them into index buckets according to where they fall, S&P index guidelines are more selective and subjective. For example, firms are supposed to have 4 trailing quarters of positive income in order to be considered for index inclusion (although the S&P index committee sometimes ignores this),” said AltaVista.