The Only Small-Cap Index ETF You Should Own

small-cap-index-etfAs I wrote on Wednesday, with small caps off to a rough year and large-caps hitting record highs, there is a compelling case to be made for buying the little guys over the big boys right now.
But not all small cap funds are created equal. And you’ll be surprised to find that there are significant differences among even the most followed funds.
Case in point: the Russell 2000 is widely heralded as the benchmark index for small cap stocks. Data for the index goes all the way back to 1979 (the actual index itself began in 1984).
But the lesser followed S&P 600 Small Cap Index is, in many ways, the superior index. Although it only dates back to 1994, the S&P 600 still has 20 years of history to consider.
And over that time this index has done better than the Russell 2000. Much better, in fact.
Given that there are low cost ETFs that track both indices, investors looking for broad-based small cap exposure should carefully consider which index they want their ETF to track.
The two main options for the respective indices are offered by iShares. These are the iShares Russell 2000 Index Fund (NYSE:IWM) and the iShares S&P SmallCap 600 Index (NYSE:IJR). For me, the hands down winner is the IJR, given that it tracks the S&P 600 Index.
According to data from Index Fund Advisors, the S&P 600 Index delivered an annualized return of 11.05% between 1994 and 2013. By comparison, the Russell 2000 Index delivered an annualized return of just 9.27%, a full 1.8% of underperformance each year.
Now, on the one hand 1.8% a year doesn’t sound like a lot. Especially if you’re getting 9.27% returns every year. But…on the other hand, why miss out on the extra performance when gaining it requires no additional work or risk? There is no good answer.
And in actuality, over time 1.8% of extra performance each year adds up to a lot of money.
Let’s assume you invest $10,000 in each fund. And let’s further assume that the same annual returns that have persisted over the past two decades continue for the next two decades.
After just one year you’ll have $135 more if you invested $10,000 in the S&P 600 versus the Russell 2000. Not bad, but nothing to write home about.
But after ten years you’ll have $3,284 more.
And in year 20, you’ll have $17,654 more. That’s worth writing home about, especially since you’ll be sitting on $81,353 by investing in the S&P 600 as compared to “just” $63,699 with the Russell 2000. The chart below shows the impact of 1.8% outperformance over time.
There are reasons why the S&P 600 tends to outperform. And they’re not that complicated. The main reason is that the Russell 2000 is just the 2,000 smallest stocks among the 3,000 largest stocks in the U.S. stock market. There is no fundamental screen layered in. Also, the index is reconstituted each year so there are trading events that are well telegraphed to the market. Both of these factors likely lead to weaker performance for the Russell 2000.
In contrast, the S&P 600 Index has a profitability screen – companies must have posted four consecutive quarters of profits to be included. And there is no annual reconstitution, so traders can’t game the index – additions and deletions are decided by a committee.
To drive home my point, check out the performance of the two ETFs that track these indices in the chart below. Since 2000, the iShares S&P 600 Index (NYSE:IJR) has risen by 275% versus just 163% for the iShares Russell 2000 ETF (NYSE:IWM). Need I say more?

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