Opinion: You own the wrong small-cap fund. How to get into a better one.

One of the good things about a market rout is that everything seems to go down together, which means everyone managing their own retirement savings gets a free, or cheap, chance for a portfolio do-over. 

As we’re in some sort of rout now, this a good time to point out that most of us are in the wrong small-cap stock funds, and this is a great opportunity to get out of it and into a better one.

Most small-cap funds follow the Russell 2000
small-cap index, which—as the name suggests—owns a broad range of 2000 stocks valued up to around $7 billion. The index dominates the fund industry. The FTSE Russell group, which manages it, says the index has an 80% market share of the small cap investment field.

One reason for this is surely habit. Wall Street, which loves nothing so much as going with the crowd, pumps out small-cap mutual funds and exchange-traded funds that track this index because everybody else does. 

The index is fine for many things, such as working out what is going on broadly with small-cap stocks. But it’s less good for us investors. That’s because it includes a vast number of unprofitable and speculative stocks that may, or may not, have any investment value at all. The basic yardstick used to value a stock is the price/earnings ratio, meaning the stock price divided by the net income per share. But the Russell 2000 is so flighty nobody can even agree on what its price/earnings ratio is. 

Is it 10 times trailing per-share earnings? That’s what it says on the home page of the iShares Russell 2000 ETF
Is it 24 times? That’s what it says on the WSJ Markets Data home page. Is it 28 times? That’s what FTSE Russell told me when I asked. 

One of the issues is how to deal with the vast number of companies in the index that have no price to earnings ratio, because while they certainly have a stock price, they, er, have no earnings.

Just over 40% of Russell 2000 companies lost money last year (yes, even during an economic boom. Just wait for the recession!). That’s more than 800 companies. How do we count those?

The standard approach is simply to ignore all those companies losing money. That estimate of “10 times” trailing earnings, for example: As iShares says, that excludes the numbers for all the companies that are losing money.

Fund companies are simply following industry practice in this regard. But what sort of valuation measure does that make it?

For another view, I asked our markets data analysis team to compare the total market value of all the companies in the Russell 2000 and their total, aggregate net income, including the losses.

Bottom line? By this measure the Russell 2000 is trading at 71 times trailing earnings. 

How’s that for value?

This problem seems to be getting worse, too. As recently as the 1990s, just 15% of Russell 2000 companies were losing money.

A spokeswoman for FTSE Russell, which manages the index, said: “We calculate P/E in different ways, and P/E ex Negative earnings is simply one calculated measure among many.” Fair enough. But investors should be aware that 40% of the stocks are unprofitable businesses. 

The Russell 2000 is not the only small-cap index available. The much narrower S&P 600
includes fewer than one third as many stocks. It generally excludes the youngest and most speculative companies and those which have never made a profit. It has, as a result, an inbuilt bias towards so-called “quality” stocks.

Over the past 12 months, FactSet data show, just over 15% of S&P 600 companies still lost money. But at least it’s not 40%.

And what of the valuation? The iShares Core S&P Small-Cap ETF
which follows this index, shows a headline P/E ratio of 11 (also excluding negative earnings). That’s about the same as for the Russell 2000, though a little higher.

But when our internal markets data team performed the same calculations for this index that they did for the Russell 2000, comparing the total market cap to the aggregate sum of all profits and losses, they found a trailing price to earnings ratio of 23.

Higher than 11. But way lower than 71.

Is there a single right answer? Maybe not. Let the marketing teams have their day. 

Nobody would argue that by the standards of history this is cheap. A P/E ratio of 23 is the same as an earnings yield of 4.3%, meaning each $1 of investment got you 4.3 cents of earnings over the past 12 months. Some might wonder how exciting stocks are with an earnings yield of 4.3% now that corporate bonds have a yield north of 6% with minimal risk. But that’s a question for another day.

Nonetheless, I’m going to stick my neck out and say that a P/E of 23 is more appealing than one of 71. 

Since the start of the millennium, iShares has run low-cost ETFs that track both small cap indexes. I compared their total return performances over that time, using the analytical tools at PortfolioVisualizer.com.

It shows what the two indexes have meant for actual investors in real money. And it tells a simple story.

During that time, the iShares Russell 2000 ETF has grown your investment overall by about 370%.

The iShares S&P 600 ETF? More than 600%. It’s not even close.

The S&P 600 fund outperformed the Russell 2000 fund in almost every year along the way. Only during sharp market rallies and bubbles, when the most speculative and risky assets suddenly come into vogue, has the broader index done better. That was true during the last three quarters of 2020 and 2009, for example. Ditto 2006.

The rest of the time, and overall, it’s been the S&P 600.

The long-term outperformance of the S&P 600 should not come as a surprise. It’s nearly 10 years since analysts at AQR Capital showed that, historically, it has been the weak, low quality stocks which have dragged down the overall performance of small-caps.

And yet so far this year it is the S&P 600 which has fallen further. The index is down nearly 6% for the year, compared to just under 5% for the Russell 2000. Since the start of the bear market, in January 2022, the Russell has declined by more, but the gap is not enormous: 24%, compared to 21% for the S&P 600. 

(Some might wonder why both numbers aren’t a lot more, given that the cost of debt capital has tripled during that time. As 40% of the Russell companies are losing money, and dependent on the debt markets, you’d think that would have hurt their stocks a lot more. But mysteries never cease on Wall Street.)

Meanwhile, this seems to offer a pretty sweet opportunity for long-term savers and investors to swap out of their more speculative Russell 2000 fund and into an S&P 600 fund.

Leave a Reply

Your email address will not be published. Required fields are marked *