Sometimes, Less Is More With Small-Cap Stocks

Small-cap stocks have been getting plenty of press lately, due in large part to some stellar post-election showings. Many investors and the financial media often focus on the Russell 2000 Index, which to be fair, is one of the most widely followed gauges of smaller stocks in the world. And to be fair, the Russell 2000 is higher by 24.2 percent year-to-date.

IJR Vs. IWM

The S&P SmallCap 600 Index is another widely followed small-cap benchmark, one accessible with the iShares Core S&P Small-Cap ETF IJR, among other exchange-traded funds. The S&P SmallCap 600 is well-known and IJR is a large, liquid ETF. Its $26.4 billion in assets under management confirm its heft and popularity.

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.

To be precise, IWM currently holds 1,945 stocks while IJR is home to 600 small caps, according to iShares data. Year-to-date, IJR is up 29.3 percent, an advantage of 510 basis points over the iShares Russell 2000 ETF IWM.

“Outperformance of the S&P SmallCap 600 versus the Russell 2000 primarily has to do with two factors: 1) the negative Russell reconstitution effect and 2) our little engine does not try pulling too many low-quality stocks up the hill.  It focuses on a manageable trainload of liquid, higher-quality names, staying clear of micro-caps that trade by appointment and other low-quality stocks,” said S&P Dow Jones Indices in a recent note.

A Sector Look

Sector differences between IJR and IWM are not massive, though there are some important differences to note. For example, financial service is IWM's largest sector weight at 19.4 percent while that group is 17.8 percent of IJR. IJR allocates 18.8 percent to industrial stocks, about 400 basis points more than IWM devotes to the same sector.

Although IJR has the smaller bench, it is often less volatile than IWM over longer holding periods. IWM's three-year standard deviation is almost 16 percent, while IJR's is just under 15.1 percent.

“Selecting the Russell 2000 historically resulted in: 1) less return per unit of risk than could have been achieved with the S&P SmallCap 600, or 2) a lower hurdle for expensive active managers to gain outsized fees—more often than not for underperformance. In short, it is advisable to remember the Little Engine That Could when implementing small-cap exposure,” added S&P Dow Jones Indices.