Small-Cap ETFs Face Off: IWM Versus IJR

Small-cap stocks, which were lagging in the first half of the year, staged a nice comeback over the past three months on talks of tax reform. The optimism intensified after the House and Senate passed the tax bill, though the version of the both the bills differ on some fronts.

With the House and Senate in negotiation on the consolidated bill, Republicans are now closer to finalize the $1.5-trillion tax reform by the end of the year. When it comes into effect, small caps will be the biggest beneficiaries relative to big companies. This is because companies on the small-cap index Russell 2000 pay a median effective tax rate of 31.9% while the larger, multi-national companies on the S&P 500 pay a median effective tax rate of 28%, according to the Thomson Reuters data. The median tax rate for the 30 mega-cap stocks on the Dow Jones Industrial Average is even low at 23.8% (read: 4 Sector ETFs & Stocks Set to Explode Higher on Tax Cuts).

Additionally, the strengthening economy is providing a boost to the small-cap stocks that are closely tied to the U.S. economy and do not have much exposure to the international market. Notably, the economy expanded at the fastest clip in three years in best back-to-back quarters with at least 3% GDP growth and unemployment at the lowest level of 4.1% since December 2000. Americans are highly optimistic about the economy with consumer confidence climbed to the highest level in 17 years.

The pint-sized stocks generate most of their revenues from the domestic market and generally outperform on improving American economic health. These are also free from the clutches of any political malaise.

Moreover, after hiking rates in December 2015 and December 2016, the Fed has raised interest rates two times this year and looks to hike rates again at its Dec 12-13 policy meeting. This indicates a stronger economy and propels small-cap stocks higher.

Given the bullish trend, investors are looking to tap the small cap space in the ETF form. The two ultra-popular ETFs — iShares Russell 2000 ETF IWM and iShares Core S&P Small-Cap ETF IJR — offer diversified exposure to the small-cap space and have a Zacks Rank #3 (Hold) with a Medium risk outlook. IWM has gained 6.9% over the past three months while IJR has returned a little more at 8.6% (see: all the Small Cap ETFs here).

Though the duo might appear similar at a glance, there are a number of key differences between the two that will explain the reason for IJR’s outperformance. We have highlighted them below:

Index Tracking

IWM tracks the Russell 2000 Index, which measures the performance of the bottom 2,000 stocks in the Russell 3000 Index. On the other hand, IJR follows the S&P SmallCap 600 Index, which is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable. As such, the index has some value tilt, as it requires companies to have at least four-consecutive quarters of positive earnings. This quality factor makes IJR superior to IWM.

Additionally, the S&P SmallCap 600 can change its constituents at any point of time due to changes in market capitalization, sector representation, profitability, and mergers and acquisitions among other reasons compared with the Russell 2000, which adopts a more rigid, once-a-year rebalance approach (read: 3 Small-Cap Growth ETFs Surging to #1 Rank on Holiday Fervor).

Holdings

IWM has a broad basket of 1,976 securities while IJR is a home to 602 stocks. Though Nektar Therapeutics (NKTR) occupies the top position in both ETFs, the former is more diversified and balanced across single security with the top 10 holdings accounting for 2.98% in IWM against 5.48% in IJR.

However, the sector exposure does not differ much for both funds with financials, information technology, industrials, health care, and consumer discretionary each taking a double-digit allocation in the basket.

Expense Ratio

IWM is the most actively traded ETF, with average daily volume of around 23.7 billion and 0.20% in expense ratio. On the other hand, IJR is relatively less liquid, trading in average daily volume of 2.6 billion, which ensures slight additional cost in the form of marginal bid/ask spread. However, the latter costs just 7 bps in annual fees, 65% less than the Russell 2000 ETF. The low fee has led to the outperformance of IJR (read: Top-Ranked ETFs That Crushed the Russell 2000 Post Election).

Assets Under Management

With AUM of nearly $36 billion, IJR is a lot smaller than $46.4 billion IWM. Additionally, the S&P SmallCap 600 ETF has accumulated just $1.9 billion over the past three months versus more than $5.6 billion for the Russell 2000 ETF.

Bottom Line

A low fee and the quality aspect have made IJR outperform IWM.

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ISHARS-R 2000 (IWM): ETF Research Reports

ISHARS-SP SC600 (IJR): ETF Research Reports

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