Consider This ETF for Small-Cap Outperformance | ETF Trends

When investors embrace small-cap stocks and the related exchange traded funds, the common expectation is that they will be rewarded with higher returns because smaller stocks are more volatile than large-cap equivalents.

While the long-term track record of smaller stocks is impressive, investors need to be mindful of a fund’s underlying index when opting for passively managed index funds and ETFs. For its part, the widely followed S&P SmallCap 600 Index has a compelling long-term track record.

But there’s more than one way to approach this venerable benchmark. Consider the Invesco S&P SmallCap 600 Equal Weight ETF (EWSC). EWSC’s underlying index is the S&P SmallCap 600 Equal Weight Index — the equal-weight equivalent of the cap-weighted S&P SmallCap 600. EWSC’s exposure to the S&P SmallCap 600 is relevant to long-term investors.

“One of the clearest examples of the importance of index construction comes when comparing the S&P SmallCap 600® and the Russell 2000. Indeed, while both indices are designed to measure the performance of the small-cap U.S. equity segment, their historical performance is a tale of two small-cap benchmarks: the S&P 600TM has outperformed by 1.8% on an annualized basis since 1994,” according to S&P Dow Jones Indices.

The S&P SmallCap 600 beat the Russell 2000 last year, but returned 32%, handily beating both small-cap benchmarks. It’s just one year, but it’s a case study in methodology mattering, and the S&P SmallCap 600’s methodology benefits EWSC.

“A key difference between the two indices is that the S&P 600, unlike the Russell 2000, employs an earnings screen; companies must have a history of positive earnings before being considered eligible for S&P 600 addition. This contributes to the S&P 600 having significant, positive exposure to the quality factor, while the same is not observed for the Russell 2000. Unsurprisingly, perhaps, the S&P 600’s relative returns have typically been higher when the reward to quality was higher,” notes S&P.

Another benefit of EWSC is that it allocates just 12.66% of its weight to healthcare stocks — its fourth-largest sector allocation. In recent months, declining biotech share prices are weighing on small-cap indexes with large healthcare weights. EWSC has more exposure to financial services, consumer cyclical, and industrial stocks.

“Another impact of the S&P 600’s earnings screen is that it has less exposure to the Health Care sector, including many biotechnology companies, as many of them lack the required history of positive earnings to be considered eligible for addition to the S&P 600,” concludes S&P.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, 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.