JSML - Small-Cap Growth ETFs: How IWO Stacks Up Against SLYG And JSML

2023-04-22 04:18:15 ET

Summary

• IWO tracks the Russell 2000 Growth Index, selecting over one thousand small-cap stocks with high price-book ratios, historical sales per share growth, and earnings growth forecasts. IWO's ER is 0.23%.
• There are few reasons to own IWO, though the ETF has still amassed nearly $10 billion in AUM. One possible reason is that investors simply aren't aware of the alternatives.
• This article highlights how IWO has performed against SLYG, a S&P 600 Small Cap Growth Fund, and JSML, a little-known peer following a proprietary strategy with a profitability screen.
• The difference in returns, as well as my fundamental analysis of the three ETFs, demonstrates why quality matters over the long run. Because IWO fails on that metric, I recommend readers avoid it.

Investment Thesis

There are plenty of growth opportunities in the small-cap market segment, but it's challenging to decipher opportunity from outright speculation. As a growth investor, you likely have a long time horizon, and in this article, I will demonstrate why you should aim to limit speculation and invest in companies that are at least profitable. Unfortunately, the iShares Russell 2000 Growth ETF ( IWO ) does a poor job selecting these companies and holds too much junk that doesn't belong in your portfolio. Still, some small-cap growth ETFs are worth considering, and I will highlight two that I think will outperform over the long run: the SPDR S&P 600 Small Cap Growth ETF ( SLYG ) and the Janus Henderson Small Cap Growth Alpha ETF ( JSML ). I hope you enjoy the analysis.

IWO Overview

Strategy Discussion: Don't Be Fooled By P/E Ratios

IWO tracks the Russell 1000 Growth Index, selecting over one thousand small-cap growth stocks based on three criteria:

1. higher price-book ratios
2. higher two-year consensus sales and earnings growth forecasts
3. higher five-year historical sales per share growth

The Index fact sheet highlights key metrics as of March 31, 2023. For example, the Index's price-book ratio (harmonic mean method) is 3.80x vs. 2.00x for the Russell 2000 Index, and the portfolio has a lower dividend yield.

Readers may view IWO's 15.93x price-earnings ratio as a tremendous deal for a growth fund, especially considering the category average on Morningstar is about five points more expensive. However, it's not that simple. The ratio excludes companies with negative earnings, which applies to 454 companies (31% of the Index weight). These ratios don't mean much without knowing this statistic, which typically isn't highlighted.

The question is how to address an issue that isn't a concern for most large-cap stocks. Morningstar applies a 60 price-earnings cap to companies with positive earnings but similarly excludes those with negative earnings. We could use the same logic and apply the cap to the 31% of excluded stocks, which drives the price-earnings ratio up to 29.15. Suddenly, IWO doesn't seem like such a great deal, so the key takeaway is to take these ratios with a grain of salt.

Sector Exposures and Key Holdings

IWO's sector exposures are listed below. The ETF overweights Health Care, Industrials, but is reasonably well-balanced across most sectors. SLYG and JSML are included as benchmarks, as both consistently outperform IWO.

IWO's top ten holdings are below. However, since there are so many holdings, all have less than 1% weighting. The list includes Health Care Technology stocks like Inspire Medical Systems ( INSP ) and Crocs ( CROX ), representing the Footwear industry. However, the most significant exposures are in Biotechnology (9.01%), Application Software (4.92%), and Health Care Equipment (3.91%), so an industry-level analysis is most appropriate.

Performance

Since JSML launched, it outperformed IWO and SLYG by 0.61% and 0.15% per year despite a higher 0.30% expense ratio. In the graph below, IWO started out somewhat strongly but then had weak returns after the Q1 2020 crash.

Compared with SLYG and the Vanguard Small Cap Growth ETF ( VBK ) since October 2000, IWO also underperformed. Using this link , readers can also see how IWO has lagged over the 3Y, 5Y, and 10Y periods. These long-term results suggest there's something inherently wrong with the approach of owning the entire small-cap growth segment. ETFs with a smaller number of total holdings tend to be more successful.

IWO Analysis

Fundamentals By Industry

The following table highlights selected fundamental metrics for IWO's top 25 industries, totaling 64% of the fund. I also included summary metrics for SLYG and JSML in the final rows.

IWO has the highest growth and valuation profile, with estimated sales, EBITDA, and EPS growth rates 3-6% higher than SLYG and JSML. IWO trades at 27.46x trailing earnings, but that metric is misleading, as discussed earlier. I used the weighted average method to calculate these figures, but if I applied the 60x cap for all ETFs, the trailing P/Es for the four ETFs would be as follows:

• IWO: 37.50x (30.85% Non-Profitable)
• SLYG: 27.28x (9.78% Non-Profitable)
• JSML: 23.15x (3.65% Non-Profitable)
• IWM: 33.32x (28.42% Non-Profitable)

Based on these recalculated ratios, SLYG and JSML are the most favorable from a valuation standpoint. SLYG, an ETF representing part of the S&P Composite 1500 Index, requires new constituents to have trailing one-year and one-quarter positive earnings but relaxes existing members' requirements. JSML's profitability requirement is more strict, which I think is why it's outperformed.

JSML may not be suitable for you. Despite the ETF structure providing additional primary market liquidity, JSML lists a high 0.27% median bid-ask spread on its fund page . Also, JSML has only $100 million in assets under management after seven years, much lower than its peers except for MMSC , which launched in October 2021. However, regardless if you buy the fund or not, its track record is another piece of evidence that suggests quality matters. Speculating is exciting, and it's great when you hit it big. However, ETFs like IWO aren't great selections if you're in it for the long run.

Other ETFs To Watch

Finally, I want to highlight how other small-cap growth ETFs performed over the last decade. There are 12 listed in the table below, including IWO, SLYG, JSML, and VBK. Of those with at least a ten-year track record, IWO and VTWG, which track the same Russell 2000 Small Cap Growth Index, performed second-worst. The top performers were the three S&P 600 Small Cap Growth ETFs (SLYG, VIOG , IJT ).

Of those with a seven-year track record, the First Trust Small Cap Growth AlphaDEX Fund ( FYC ) performed second-best behind JSML with a 95.36% gain. FYC is more concentrated with 263 holdings, reconstitutes quarterly, and has even higher estimated growth than IWO, so it seems most appropriate for aggressive investors. Please let me know if any of these names catch your eye and if you want more detailed coverage.

Investment Recommendation

Profitability matters when evaluating small-cap growth stocks. However, IWO has no suitable profitability screen, so its underperformance is unsurprising. Unfortunately, there are so few small-cap growth ETFs on the market. Even though ETFs like JSML are performing better, their assets under management pale compared to worse-performing funds and generally have liquidity issues that steer many investors away.

SLYG is a much better choice than IWO, so at a minimum, I recommend investors avoid IWO. However, unless JSML's liquidity problems aren't problematic for you, it might be best to avoid the segment altogether and move toward mid-cap growth ETFs. Thank you for reading, and I look forward to the discussion in the comments below.

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