2023-12-18 17:57:35 ET
Summary
- iShares Core S&P Small-Cap ETF has outperformed the Russell 2000 and S&P 500.
- Small-cap companies have the potential for high returns but also higher volatility.
- The ETF tracks the SP Small Cap 600 index and includes profitable smaller companies with positive earnings.
Summary
I have long perceived the small-cap world as an asset class with far greater potential returns and volatility or Beta since companies in this area are more susceptible to macro drivers and disruptions. I have frequently focused my investment attention on the Russell 2000 as a broad index to gain exposure to small caps. In a recent search for small-cap ETFs, I came across iShares Core S&P Small-Cap ETF ( IJR ) that to my surprise has handsomely beaten the Russell 2000 and SP500 ( SPX ).
Why Small Caps
In my experience, there are two types of small-cap companies, those with managerial vision and execution to become large caps i.e. growth and innovation, and those that become mature in a seemingly benign ecosystem that may slowly wither. The good small caps grow faster and generate compounding returns for investors, however, identifying these companies is not an easy task, and thus investing via an ETF or fund is a lower-risk option.
Performance
I initially began my search for small-cap funds by reviewing the Russell 2000 performance vs the SPX and added to the comparison the IJR and was surprised with its exceptional performance, so I dug deeper to understand why. The key is that the IJR tracks the SP US Small Cap 600 index and not the Russell 2000.
To better understand this outperformance, I matched the annual price return of the IJR and the SPX and found that this 600 stock small cap index was more volatile but earned on average 2.3% per year over the SPX. I calculated an over/under spread for the IJR vs SPX where for example if the SPX gained 10% and the IJR 12% the positive spread is 2%. However, there are years that the SPX is positive and the IJR negative which results in a very wide negative spread. This is highlighted in 2023 where so far, the SPX is up 23% and the IJR is up 4% for a -19% spread or Alpha.
IJR vs SPX, Russell 2000 (Created by author with data from Capital IQ)
Yearly Performance IJR & SPX (Created by author with data from Capital IQ)
Alpha for IJR vs SP500 (Created by author with data from Capital IQ)
Index Construction
The IJR tracks the SP Small Cap 600 and chooses from an investable universe of 1500 stocks with several Key criteria . First, all of the 1500 stocks must have had positive earnings in the last four quarters, this weeds out many start-ups and more aggressive growth companies. The second is the market cap threshold of US$850m, which also eliminates microcaps. This index and by default the IJR ETF is made up of profitable smaller companies that generally have higher results in a positive macro environment. This means GDP growth, sector-specific drivers, and the accessibility and affordability of credit.
SP Index Criteria (SP Global) SP Index Criteria (SP Global)
Portfolio Composition
When I analyze a fund, I normally gather consensus estimates for a sizable portion of the portfolio and then calculate upside potential, EPS growth, valuation, etc. In this case that is not feasible with 600 stocks with a below half a percent weight each. Instead, I compared the sector weights vs the SPX. Here I find a significant underweight in the tech sector (information and communications services) and a large overweight in industrial and financials. These two sectors, especially in the small-cap space, have seen earnings stress on debt cost or in the case of banks funding costs.
IJR Sector Weights (Created by author with data from Capital IQ)
Valuation
Small caps are not cheaper than big caps, at least that’s what the data I gathered from the Forward PE of the Russell 2000 vs the SPX suggests. I did not have access to the SP Small Cap 600 index. However, the gap tightened in 2022 and 2023 as the asset class underperformed. If the Fed does reduce rates and the economy does not go into a recession, small caps could recuperate their valuation premium. I doubt that macro weakness occurs before a rate cut which bodes well for valuation, at least through 1Q24.
PE of Russell 2000 & SPX (Created by author with data from Capital IQ)
Conclusion
I rate the IJR a Buy. This ETF only includes small-cap stocks with positive earnings and has outperformed the SPX in the last 20 years, albeit with far higher volatility. In my view, small caps may recuperate their valuation premium in 2024 on Fed rate cuts as well as see better results on lower credit costs. The 19% weight in financials (regional banks) was especially hit hard by the Fed action and may begin to ease funding costs and improve EPS.
For further details see:
IJR: This Small Cap ETF Makes Alpha