Size Matters With Small-Caps ETFs

There are massive sums of money sitting in various small-cap exchange traded funds, but in some cases, investors may not be getting the small-cap purity they signed up. Part of the reason for this could be that there isn't a uniform definition of “small cap,” though widely accepted definitions usually use $2 billion as the cut off for small stocks and the start of the mid-cap arena.

A small-cap ETF's weighted average market value is an integral determinant of the fund's performance. Said another way, in a good year for small caps, such as 2016, investors looking for small-caps exposure don't want to be in an ETF that is a mid-cap fund in disguise.

“While we certainly couldn’t say that this would always be the case, the more important point is that—even though these are all Indexes focused on U.S. small-cap stocks—there was a spread of greater than a cumulative 20% between the top and bottom performers,” said WisdomTree in a recent note. “It clearly matters how the exposure is garnered. 2016 is an example of a year when the small-cap theme worked well, and it’s interesting that the small-cap Indexes from CRSP and MSCI that had higher weighted average market capitalizations did not perform as strongly.”

Take the case of the WisdomTree SmallCap Dividend Fund DES. DES has a long tradition of topping active small-cap funds as well as non-dividend ETF rivals, with much of that outperformance owed to dividends. However, the weighted average market value of the nearly 700 stocks found in DES's underlying index is below that of some widely followed small-cap benchmarks, a contributing factor in the ETF's out-performance.

DES competes with ETFs such as the Vanguard Small-Cap ETF VB, which follows the CRSP US Small Cap Index, and the Vanguard Small-Cap Value ETF VBR. VBR also tracks a CRSP index. The indexes VB and VBR track apparently have a loose interpretation of “small cap” because VB and VBR's holdings have median market values of $3.7 billion and $3.6 billion.

The size impact was clear in last year's returns. VB and VBR returned 18.4 percent and 24.9 percent, respectively, while DES surged 31.4 percent. Notably, investors didn't have to take on significantly more volatility to embrace DES. That ETF's annualized volatility last year was 17.1 percent compared to an average of 16.7 percent for VB and VBR.