3 ETFs to Buy to Ride a Small-Cap Revival

Will Ashworth - Barchart - Tue May 16, 2023

Barron’s published a Q&A article recently with small-cap growth investor Rayna Lesser Hannaway, a portfolio manager with Polen Capital, an investment management firm with more than $61 billion in assets under management.

The headline -- Small-Cap Stocks Have Been Crushed. 3 With Big Potential. -- describes perfectly the performance of small-cap stocks in recent years. They’ve been crushed. In the past five years, the S&P SmallCap 600 Index is up 11.7%, less than half that of the large-cap S&P 500.

According to the annual periodic table of asset class performance from A Wealth of CommonSense, small-cap stocks haven’t led the table since 2016. Reversion to the mean suggests the asset class is about due for a victory lap.

“We have been talking for a long time about how we believe we may be on the front end of the next small-cap supercycle. In seven out of the past 10 years, large-cap growth beat small-cap growth. That equated to five percentage points of annualized underperformance from 2013 through 2022,” Hannaway said in Barron’s interview.

So, it’s time to consider three small-cap ETFs to ride the impending wave of smaller stocks. Here are three ETFs to make a bet on the future.

A Value Play

First up is the iShares S&P Small-Cap 600 Value ETF (IJS). It tracks the performance of the S&P SmallCap 600 Value Index, a collection of stocks exhibiting the strongest value characteristics from the S&P SmallCap 600.

IJS has 495 holdings with an average market cap of $1.67 billion, a P/E ratio of 10.0x, and a P/B of 1.2x. Given the additional risk, the ETF spreads around its bets. The top 10 holdings account for just 8% of its $6.5 billion in net assets.

The top three sectors by weight are consumer discretionary (19.62%), financials (17.23%), and industrials (16.41%). Stocks representing these three sectors are Meritage Homes (MTH), one of America’s top homebuilders; Radian Group (RDN), a provider of mortgage insurance; and John Bean Technologies (JBT), a maker of food processing equipment and airport equipment.

As for fees, IJS charges a reasonable 0.18%, or $18 per $10,000 invested.

If you’re into options, selling June 16 $86 puts looks interesting. As I write this, it’s got a bid price of $1.10 for a 1.3% yield. On an annualized basis, that’s 15.3%. With 31 days to expiration, the odds of having the shares put to you are probably 50/50.

A Growth Play

For the growth play, I’m going with the JPMorgan Diversified Return U.S. Small Cap Equity ETF (JPSE), which tracks the performance of the JP Morgan Diversified Factor US Small Cap Equity Index. The rules-based index utilizes factors such as value, quality, and momentum to select the components that make up its constituents.

Morningstar rates it four stars out of five and considers it a small-cap blend rather than a straight-up growth fund. The weighted average market cap is $2.87 billion with P/E and P/B ratios of 12.42x and 1.61x, respectively. Both ratios are higher than the value ETF from above.

The ETF has 576 holdings, with the top 10 accounting for less than 4% of its $385 million in net assets. The top three sectors by weight are health care (11.4%), industrials (10.9%), and tied for third are technology and financials (10.8%).

Three names you might recognize in the top 10 include Taylor Morrison Home (TMHC), an Arizona-based homebuilder; Celsius Holdings (CELH), a functional beverage company partially owned by PepsiCo (PEP); and Coca-Cola Consolidated (COKE), the largest independent Coca-Cola bottler in the U.S.

A Further Afield Play

The one thing you’ll notice about this final small-cap pick is that its performance year-to-date is much better than the other two funds.

The Vanguard FTSE All-World ex-US Small-Cap ETF (VSS) is up 6.3% YTD, compared to a 1.4% drop for JPSE and a 3.8% decline for IJS. This is because international small-cap stocks do best in rising interest-rate environments.

Very inexpensive at 0.07%, the median market cap of its 4,269 holdings is $1.7 billion, while the P/E and P/B are 12.4x and 1.3x, respectively, about the same as JPSE.

Developed markets account for 75% of the fund’s $8.5 billion net assets, with emerging markets accounting for the rest. The top three countries by weight are Canada (15.6%), Japan (13.6%), and the United Kingdom (9.60). As the ETF’s name implies, it invests everywhere but in the U.S.

With mostly Canadian companies in the top 10, American investors will probably recognize Cameco (CCJ), Ritchie Bros. Auctioneers (RBA), and Open Text (OTEX).

Of the three ETFs covered in this article, VSS is undoubtedly the one with the most momentum. However, if you compare its performance over the past five years -- it’s down nearly 9.0% -- VSS is significantly lagging behind IJS (up 8.1%) and JPSE (up 23.5%).

Each of the trio is interesting in their own way. However, regarding long-term, risk-adjusted returns, JPSE is your best bet to ride the impending small-cap wave.

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On the date of publication, Will Ashworth did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.