How Small-Cap ETFs Impact the Market, Active Managers

February 23rd at 10:22am by John Spence

The popularity of exchange traded funds that invest in U.S. small-cap companies may be having an impact on the market’s less-liquid stocks, and could even be making it more difficult for active managers to outperform the index.

“Active managers have been fighting an uphill battle against the growing influence of ETFs in the U.S. smaller companies sector,” the Financial Times reports Thursday.

“When ETF flows are strong, active managers tend to struggle to get ahead of their benchmarks and when flows are weak, active managers tend to outperform,” said Steven DeSanctis, head of U.S. small cap strategy at Bank of America Merrill Lynch Global Research, in a research paper.

U.S. small-cap ETFs have accounted for nearly 90% of total fund inflows to the sector over the past 10 years, the FT reports. Since 2002, $32.7 billion has flowed into small-cap ETFs.

The largest ETF in the category is the $16.8 billion iShares Russell 2000 (NYSEArca: IWM). The small-cap fund is up 10.6% year to date, compared with an 8.3% gain for the S&P 500, according to Morningstar. The ETF has an expense ratio of 0.26%.

Small-cap shares are more volatile than blue chips and outperform when investors are adding more risk.

“Small-cap stocks tend to be more volatile due to narrower economic moats and a greater sensitivity to macroeconomic risks, but with this greater volatility comes a higher beta and the expectation for higher returns,” says Morningstar’s Michael Rawson in a profile of IWM. “For those who want to reap this size premium, be forewarned that the returns for smaller stocks can vary drastically over time, and the premium has reliably appeared only over periods of a decade or more.”

DeSanctis at BofA Merrill Lynch said in months when IWM had the biggest inflows, small-cap active managers underperformed the Russell 2000 by 43 basis points, according to the FT story. In the months when IWM had the biggest outflows, active managers outperformed the benchmark index by 36 basis points.

Yet the analyst said it’s “a little too simplistic” to conclude activity in IWM has a “dramatic impact” on an active manager’s outperformance or underperformance, the newspaper reported.

“This is because IWM’s flows have a very close relationship with the direction of the Russell 2000. In those months when IWM’s inflows were largest, the index rallied about 78% of the time. In the months when IWM’s outflows were bigger, the index retreated 63% of the time,” the FT said.

iShares Russell 2000


The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

Tickers

IWM