Small cap indexes represent 8-16% of the total US stock market. But many investors have no small cap exposure at all. They own strictly large companies. Thoughtful investors will equal-weight or even overweight small cap ETFs because historically small caps outperform their large cap brethren.
The chart below compares the small cap ETF iShares Russell 2000 Index (NYSEArca:IWM) with the large cap SPDR S&P 500 (SPY:NYSEArca).
The performance of the two ETFs in chart above is similar. Yet the funds shown here have effectively no overlapping holdings. IWM tracks the Russell 2000. The weighted average market cap of the Russell is about 1.5 billion. It median market cap is 0.6 billion. The S&P 500 has an average weighted market cap of about 24 billion. Its median market cap is 11.3 billion.
The chart above goes back just five years. Longer-term, small cap has performed better. In a study that tracks a 50-year period from 1956-2005 Fama and French concluded that small caps outperform large caps by 4% annually.
There are many reasons for a long-term outperformance of small cap. Smaller companies tend to be more nimble. They adapt quickly to market conditions. They are less hamstrung by bureaucracy than larger companies. And small companies are often acquired, boosting their price.
But there are risks in investing in small cap. Small cap ETFs hold less established companies. They tend to be more volatile than large cap ETFs. In times of market stress small cap companies typically underperform. They are more quickly sold.
What kind of underperformance can investors in small cap expect in weak markets? The iShares Russell 2000 Index (NYSEArca:IWM) has a beta of 1.20. Benchmark large cap ETFs that track the S&P 500 Index such as the SPDR S&P 500 (SPY:NYSEArca) have a beta of 1.00. If the SPY falls 1 point, expect IWM to fall 1.2 points. Of course, the same on the way up: for every 1 point the SPY goes up, expect IWM to go up 1.2 points. In strong markets small cap ETFs will usually outperform large cap funds.
Although they mostly perform similarly, small cap ETFs are not all alike. Small cap companies lie within the 750 to 2000 US stocks ranked by size. But some small cap ETFs hold relatively smaller companies within this range. Some hold relatively larger companies in this range.
Investors seeking exclusively small companies will want to examine IWM.
For more broad offerings investors should consider Vanguard's Small-Cap ETF (NYSEArca:VB). This ETF includes mid-cap companies at one end, micro-cap at the other.
iShares S&P 600 Small Cap Index (NYSEArca:IJR) targets a tight band of larger-than-average small firms. It is one of the most popular small cap ETFs by volume.
Fees for the basic small-cap ETFs range from about 0.10% per year to about 0.25%. Although its net assets are smaller than some of the other funds, VB is a good choice for an investor with no specific index target in mind.
Like in other asset classes, even among very similar ETFs there is sometimes deviation. The SPDR and Vanguard products for example seem to use identical indexes. Both follow stocks ranked 751-2500. But the DJ Wilshire Small Cap Index and the MSCI US Small Cap 1750 Index commonly deviate by 1% per year, or more. 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 any one index better for the long-term just because it outperforms over specific periods. Reversion to the mean will likely occur. Still, it remains instructive to see how indexing methodology can cause two seemingly identical ETFs to diverge at times.
A list of popular small cap ETFs follows:
Plain Vanilla Small Cap ETFs
Focused Small Cap ETFs
International Small Cap ETFs
Sub-Sector Small Cap ETFs
Fundamental Small Cap ETFs
Leveraged/Short Small Cap ETFs