1 Clear Winner Among Small Cap ETF Offerings

Adam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

$191 billion was invested in ETFs in 2012, the strongest net inflows into ETFs in history.  In fact, $37.7 billion was invested in December alone.  Total assets invested in ETFs is now $1.35 trillion.  From these numbers, it is obvious that investors are becoming more comfortable with ETFs.  Given the total assets invested in ETFs and an average expense ratio of 0.44%, nearly $600 million is paid annually in fees to ETF providers.

One sector which I have noticed has widely varying expense ratios is Small Cap indices.  There are upwards of 75 ETFs geared towards different types and styles of small cap indices.  In this article, I look at some factors which I consider important in selecting a small cap ETF for my portfolio.  First, I look at the index the ETF tracks and the number of companies in the ETF. 

Each index covers a slightly different portion of publicly traded companies.  For instance, the S&P 600 covers only 3% of the market cap of the US equities market, while the Russell 2000 covers roughly 10%.  To prevent overlap in a portfolio, it is helpful to use the same parent company’s indices for your portfolio.  If you hold funds that index both the Russell 2000 and the S&P Midcap 400, you have a higher than expected weighting on Mid-cap companies because the Russell 2000 holds many companies that the S&P considers to be mid-cap.

Minimizing expense ratios is a key tenant of long term investor success.  Every dollar lost to expenses is a dollar that cannot continue to compound.  I’ll focus on ETFs for the S&P 600 index specifically, since there are more ETFs on this index of any small cap index.  Also, since most investors index to the S&P 500, it makes sense to use the same parent company of the index for small cap exposure as well.

I like to look at the size and liquidity of ETFs before I invest in them.  ETFs must reach a certain size before the provider is able to make a profit on them.  If a provider is unable to profit off of an offering, they could close it at any time, resulting in unnecessary hassle.  From what I can tell, ETFs with more than $100 million in assets are profitable enough for the issuer to prevent closing.  Also, the average daily trading volume of the ETF is an important statistic to look at.  As liquidity increases, the correlation with the intrinsic value increases.  Intrinsic value is the value of the underlying assets.  An average daily trading volume of 30,000 shares per day is good enough to keep the price close to the intrinsic value.

Another factor that I consider important when selecting index ETFs is a liquid options market.  I utilize options in my investing strategy sometimes to protect myself by buying a put (or selling a call), or to leverage over-reactions by buying a call.  To keep the option strategies simple, I like to buy protection in the instrument I’m invested in. 

In the table below I lay out each of the factors I consider for the four different ETFs that track the S&P 600.  The ETFs are offered by Vanguard (NYSEMKT: VIOO), iShares (NYSEMKT: IJR), SPDR (NYSEMKT: SLY), and RevenueShares (NYSEMKT: RWJ).  Keep in mind that the underlying assets of these ETFs are all the same: the S&P 600 Small Cap index.

<table> <tbody> <tr> <td> <p>Ticker</p> </td> <td> <p>VIOO</p> </td> <td> <p>IJR</p> </td> <td> <p>SLY</p> </td> <td> <p>RWJ</p> </td> </tr> <tr> <td> <p>Index Monitored</p> </td> <td> <p>S&P Small Cap 600</p> </td> <td> <p>S&P Small Cap 600</p> </td> <td> <p>S&P Small Cap 600</p> </td> <td> <p>S&P Small Cap 600</p> </td> </tr> <tr> <td> <p>Number of companies in index</p> </td> <td> <p>600</p> </td> <td> <p>600</p> </td> <td> <p>600</p> </td> <td> <p>600</p> </td> </tr> <tr> <td> <p>Expense Ratio</p> </td> <td> <p>0.15</p> </td> <td> <p>0.16</p> </td> <td> <p>0.20</p> </td> <td> <p>0.54</p> </td> </tr> <tr> <td> <p>Options Market?</p> </td> <td> <p>No</p> </td> <td> <p>Yes</p> </td> <td> <p>No</p> </td> <td> <p>No</p> </td> </tr> <tr> <td> <p>Average Daily Volume</p> </td> <td> <p>7,925</p> </td> <td> <p>919,143</p> </td> <td> <p>15,657</p> </td> <td> <p>17,002</p> </td> </tr> <tr> <td> <p>Assets (in billions)</p> </td> <td> <p>0.154</p> </td> <td> <p>8.100</p> </td> <td> <p>0.229</p> </td> <td> <p>0.122</p> </td> </tr> </tbody> </table>

From the table above, the iShares S&P 600 ETF is the only offering that fits all of my investment criteria.  It does not have the lowest expense ratio, but only by a difference of 0.01%, or $1.00 for every $100,000 invested.  It does have an options market that is somewhat liquid, and it trades over 900,000 shares per day.  The expense ratio of IJR is also several basis points lower than the popular Russell 2000 index ETF from iShares – IWM.

As I re-balance my portfolio over the next several months, I plan to consolidate my small cap investments into the IJR ETF because I believe this is one of the best small cap index ETFs trading today.


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