Key Points
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The Russell 2000 has outperformed the S&P 500 by about 4% over the past year.
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Quality and value-oriented small-caps have done even better.
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Here’s the small-cap ETF that I think has the best potential moving forward.
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Ever since large-cap tech stocks starting melting down in October, small-caps have become outperformers again. And for good reason. Their combination of accelerating earnings growth, reasonable valuations, and fewer questions around artificial intelligence (AI) capex spending make this an intriguing entry point for this group.
There are dozens of ETFs focused on small-caps but I want to look at the major ones here:
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- iShares Russell 2000 ETF (NYSEMKT: IWM)
- iShares Core S&P Small-Cap ETF (NYSEMKT: IJR)
- Vanguard Morningstar Small-Cap ETF (NYSEMKT: VB)
- Schwab U.S. Small-Cap ETF (NYSEMKT: SCHA)
- iShares Russell 2000 Value ETF (NYSEMKT: IWN)
- Vanguard Morningstar Small-Cap Value ETF (NYSEMKT: VBR)
ETFs for broad small-cap exposure
The biggest difference that matters most in this category is the one between the iShares Russell 2000 ETF and the iShares Core S&P Small-Cap ETF.
The iShares Russell 2000 ETF holds essentially all stocks, profitable and unprofitable, within its target universe. The S&P 600 index, which the iShares Core S&P Small-Cap ETF tracks, has a screen that requires companies to be profitable in order to be included. That means it has a quality tilt that the others don’t necessarily have.
The other two are built a little differently. The Vanguard Morningstar Small-Cap ETF has a median market cap of $10.7 billion, giving it a distinct larger company tilt. The Schwab U.S. Small-Cap ETF has a more modest median market cap of around $5 billion, making it more representative of what investors might more likely consider to be small-caps.
All four have a case for use as a core small-cap position. I like the iShares Core S&P Small-Cap ETF because of its quality tilt and I think that’s a good strategy when shopping in this space. A large percentage of small-cap companies are unprofitable and that can lead to deeper drawdowns in bear markets.
Tilting toward small-cap value stocks
The small-cap value category has become interesting lately. Normally, this is the segment where quality is an issue, where cheap stocks are cheap for a reason. But despite the issues with the Iran war, high inflation, and high interest rates, they’ve been staging an impressive rally.
Over the past year, the Vanguard S&P 500 ETF (NYSEMKT: VOO) is up roughly 15%. But the iShares Russell 2000 Value ETF and the Vanguard Morningstar Small-Cap Value ETF are up 27% and 24%, respectively.
They both buy cheaper small-cap stocks but use different methods for getting there.
The iShares ETF only uses the price/book (P/B) ratio to select stocks, has a high 29% allocation to financial stocks, and a forward price/earnings (P/E) ratio of around 15. The Vanguard ETF uses multiple traditional valuation metrics to target stocks, has roughly half of its portfolio in a combination of industrials, financials, and consumer discretionary stocks, and a P/E ratio of around 16.
The Vanguard Morningstar Small-Cap Value ETF would be considered the more diverse of the two portfolios, but the iShares Russell 2000 Value ETF is more of a pure small-cap play.
Which small-cap funds have the strongest case right now?
In terms of short-term potential, I think the broad small-cap ETFs have a better case than the small-cap value ETFs.
The expected earnings acceleration over the next two years should be a strong catalyst for a further rally. I’d expect broader exposure and its heavier growth tilt over value will potentially perform better.
Over the longer-term, I still like the iShares Core S&P Small-Cap ETF and its link to the S&P SmallCap 600 index. I think the profitability requirement when investing in small-caps is important and helps weed out some of the junk that may not survive long-term. Over time, quality tends to win and I think that’s the best way to approach this category.
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David Dierking has positions in Schwab Strategic Trust-Schwab U.s. Small-Cap ETF. The Motley Fool has positions in and recommends iShares Core S&P Small-Cap ETF. The Motley Fool has a disclosure policy.
