VettaFi Voices On: The Surprises Inside Small-Cap ETFs | ETF Trends

Small-cap ETFs have started the year hot relative to other investment factors, whether thanks to their valuations or their ability to be nimble. Today, the VettaFi voices gather around the water cooler to talk about how best to understand small-caps and peel back some of the misconceptions around the asset class.

Todd Rosenbluth, director of ETF research: Love this topic! At the end of January, VettaFi asked nearly 300 advisors, “Which market sector(s) do you believe offer attractive investment opportunities over the next 6-12 months?” The overwhelming choice was small-caps (59%), ahead of innovation/technology (44%), industrials (33%), and large-caps (32%), though advisors could and often did select more than one style. (For more on this poll, check out my recent Chart of the Week: “Advisors Favoring Small-Cap ETFs in 2023.”)

Lara Crigger, editor-in-chief: I wonder how much of that had to do with the fact that small-caps have been beating the pants off large-caps. For example, over the past year, the biggest small-cap ETF, the iShares Core S&P Small-Cap ETF (IJR), has outperformed the iShares Core S&P 500 ETF (IVV), 9% to 3%. (A short time frame, I know, but still the one we see the most inquiries on!)

Rosenbluth: No doubt return has a lot to do with it. Small-caps generally have outperformed large-caps, but small-cap value has been much stronger than growth this year. For example, the iShares S&P Small-Cap 600 Value ETF (IJS) is up 10% year-to-date, while the iShares S&P Small-Cap 600 Growth ETF (IJT) is up only 6.5%. In contrast, the larger-capitalization S&P 500 Value and S&P 500 Growth Indexes are largely performing in line with one another.

Crigger: A good reminder that value and growth portfolios don’t always hold the stocks you think they do!

Rosenbluth: True. A few more things to note about small-caps. First, they are higher reward, but also higher-risk, and advisors came in 2023 more willing to embrace risk again. Second, they are more U.S.-centric than large-caps, and therefore less impacted by the direction of the U.S. dollar.

That said, advisors really should be using the diversification benefits ETFs offer to gain exposure to the class. Whether that is using less expensive index-based products like IJR, the iShares Russell 2000 ETF (IWM), or the Vanguard Small Cap ETF (VB); smart beta ETFs like the Goldman Sachs ActiveBeta US Small Cap Equity ETF (GSSC) and the iShares MSCI USA Small-Cap Multifactor ETF (SMLF); or active ETFs like the Avantis U.S. Small Cap Value ETF (AVUV) or the Dimensional U.S. Small Cap ETF (DFAS), I think that ETFs make a lot of sense for advisors. Picking individual small-cap stocks is a fool’s game.

I’m curious what Roxanna thinks about using thematic ETFs to gain exposure to small-caps. I know the Procure Space ETF (UFO) and the Invesco Alerian Galaxy Blockchain Users and Decentralized Commerce ETF (BLKC) have a mix of large- and small-caps — as does the Alerian MLP ETF (AMLP), right, Stacey?

Stacey Morris, head of energy research: Looking at the constituents for the index that underlies AMLP, the smallest market cap is still comfortably over $1 billion. You will find more of the smaller MLPs in the broader Alerian MLP Index (AMZ), which underlies a couple ETNs. MLP investors are generally more interested in the income on offer than the market cap exposures.

Rosenbluth: That’s a good point. IJR is tied to the S&P small-cap index that has a median market cap of $1.4 billion, but VB from Vanguard has a median market cap of $5.8 billion. So one index provider’s small-cap is another one’s mid-cap.

Roxanna Islam, associate director of research: Thematic investing actually isn’t as small-cap biased as you would think, Todd, but I’m glad you brought that up. Typically, you have new, emerging companies that enter a specific industry as disruptors. These are often higher-risk, smaller-cap companies. Many of these popped up only recently. (Remember the SPAC craze?) On the other hand, you have incumbent companies that operate within an adjacent space. These large- or mega-cap companies can adapt to changing trends relatively quickly given their scale, existing customers, and industry relationships.

Rosenbluth: This is why I love these VettaFi Voice discussions for not just my ability to learn from my colleagues, but for the investment community to do so too. Love to be corrected by smarter people to set me straight!

Islam: Electric vehicles is a great example industry. Within EVs, you have several newer, small-cap pure-play companies like Fisker (FSR), which didn’t go public until 2020. Currently the company sits at about $1.3 billion market cap. Production is ramping up slowly, which is typical given a smaller company’s resources, including cash, supplier relationships, and facilities.

Then you also have all the legacy automakers like Kia Corp (000270 KS) and Ford Motor Co (F). While these companies still focus on internal combustion engine (ICE) vehicles, they have more easily been able to produce electric vehicles and ramp up production, given their resources. While some people would argue that these companies shouldn’t count because they’re not pure-play companies, they actually contribute more revenue to the electric vehicle space when compared to a newer pure-play company in its pre-delivery stage.

You see similar scenarios across many themes. Within the space sector, you also have newer and smaller space exploration companies like Virgin Galactic (SPCE) along with large, longstanding commercial and satellite companies like Iridium Communications (IRDM). Within the blockchain sector, we also see lots of newer, small-cap crypto related equities like Marathon Digital (MARA) that exist with larger tech-forward financial companies like Mastercard (MA).

Rosenbluth: Agreed. Back when I was a financial advisor, we would look to own a company like Fisker or Marathon Digital and pray it worked out, but hate it when the short-term reality of owning a small-cap company did not match the long-term thematic potential. This is why thematic ETFs are so much better for an advisor with a client that has conviction in the trend.

Islam: So for thematic ETFs you’ll often see both types of companies held within the ETF. These ETFs are also typically market-cap weighted, so the larger-cap constituents (i.e., the industry incumbents) get higher percent weightings. Particularly for index-linked ETFs, which are rules-based, there’s also minimum market caps and minimum volatility guidelines that help prevent the ETF from being filled with the higher-risk emerging companies.

For example, an ETF like the First Trust S-Network Future Vehicles & Technology ETF (CARZ) actually has a median market cap of $93.5 billion. UFO and BLKC also have median market caps of $3.9 billion and $121.2 billion, respectively.

While those median market cap data points give us insight into the types of holdings within the ETF, weighted market cap data points actually tell us more about the ETF. The above three ETFs have average weighted market caps of $377.5 billion, $3.9 billion, and $121.2 billion, respectively — much larger relative to the median market caps of the holdings. But the smaller-cap constituents tend to be more “exciting” and “newsworthy,” so many investors and advisors believe thematic ETFs are more small-cap oriented than they really are.

But that’s really one of those benefits of investing in a trend through an ETF vs. a single stock, as Todd just mentioned — you can participate in that trend without having a lot of single-stock risk, especially when these newer companies have less public data and analyst research available.

I think overall when we see investors regain interest in small-caps, that does benefit thematic ETFs — not just because of the stereotypes mentioned above but also because most trends dealing with technology and innovation fit into that higher-risk/higher-reward category. I’ve personally heard a lot of interest return back to crypto equity ETFs, for example, as investors look to taking on more risk (and doesn’t hurt that nine out of the top 10 performing equity ETFs YTD are crypto ETFs).

Rosenbluth: ROBO Global Robotics & Automation ETF (ROBO) is another thematic ETF that comes to mind that has mostly mid-caps per ETF Database, but 14% in small-caps.

My final take is one I will use forever, because it never goes stale: What’s inside an ETF is important and requires a little homework. You always should take the time to look under the hood of your ETF!

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