Andrew Goldman has been writing for over 20 years and investing for the past 10 years. He currently writes about personal finance and investing for Wealthsimple. Andrew's past work has been published in The New York Times Magazine, Bloomberg Businessweek, New York Magazine and Wired. Television appearances include NBC's Today show as well as Fox News. Andrew holds a Bachelor of Arts (English) from the University of Texas. He and his wife Robin live in Westport, Connecticut with their two boys and a Bedlington terrier. In his spare time, he hosts “The Originals" podcast.
Investing in small cap stocks is valid part of a well-diversified portfolio. The Russell 2000 index is a major index that tracks U.S. small cap stocks.
What is the Russell 2000?
The Russell 2000 is an index of domestic small cap stocks. The index was created by and is run by the Frank Russell Company, a group that manages several stock market indexes and provides other investment services.
The Russell 2000 consists of the smallest 2,000 stocks contained in the Russell 3000 index, a benchmark of the total U.S. stock market. According to their site, Russell offers eight U.S. benchmark indexes covering a range of stocks from small to mega caps. The company also offers a number of worldwide benchmarks as well.
The Russell 2000 index is a market cap weighted index, meaning that the components of the index (the stocks included) are included in proportion to their relative market capitalization. Market cap is calculated as the number of total shares of the stock outstanding in the market times the price per share of the stock.
Market cap weighting can be a big issue in some indexes like the S&P 500 where a small number of the stocks included in the index comprise a disproportionate percentage of the index. These stocks can have a disproportionate impact on the index’s performance in extreme market conditions.
This is not the case with the Russell 2000. According to Morningstar, the top holding of the iShares Russell 2000 ETF (ticker IWM) as of April 28, 2019 made up 0.41% of the total assets of the fund. These percentages can and do change as the price of the underlying stock holdings go up or down during the trading day and over time. IWM is an index ETF based upon the Russell 2000.
Morningstar breaks down U.S. stocks by market cap as follows:
Large cap stocks are defined as those in the top 70% by market capitalization.
Mid-cap stocks are defined as those generally with a total market cap in the $1 billion to $8 billion range. Morningstar indicates that they usually make up about 20% of the total U.S. market by market capitalization.
Small caps are defined as those stocks in the bottom 10% of the total U.S. equity market ranked my total market capitalization.
Looked at another way, large cap stocks are often the stocks of major corporations. Microsoft, Disney, Apple, Google (Alphabet) and many other household names are examples of large cap stocks. These companies usually have a number of product lines, so if one area of the company has some problems it often won’t be a disaster for the stock.
Small caps are often smaller companies that may only have one or two product lines. They also may not have the internal infrastructure and systems in place as with a large company. If their main product or service line hits a snag, this could spell big trouble for the company and their shares. On the other hand. Some small caps go onto to become successful and turn into large cap stocks. (Apple is the best example of this.)
List of Russell 2000 ETFs
According to ETF.com, there are ten U.S. ETFs that track the Russell 2000 index.
The largest by far is the ishares Russell 2000 ETF (ticker IWM). According to Morningstar, the fund’s assets were just under $40 billion as of August 27, 2019. The fund’s expense ratio is a reasonable 0.19%.
The next largest ETF that tracks this index is the Vanguard Russell 2000 ETF (ticker VTWO). The fund’s assets were $1.465 billion as of July 31, 2019. The expense ratio was also low at 0.15%.
The other eight funds listed by ETF.com use the Russell 2000 as the fund benchmark but invest in various types of strategies with the Russell 2000 as a base line.
These ETFs use strategies like:
Shorting the index. This means that they sell some or all of the stocks in the index betting the shares will decline in price. This can pay off stock prices because often decline but can be risky if their bet is wrong.
A couple of these ETFs use leveraged strategies, meaning they are betting the index goes up or down and use strategies to magnify the returns two or three times in the case of those on this list. Again, this is beneficial if the fund’s bet on the index direction is correct but can result in magnified losses if they are wrong. These funds are very risky for investors who don’t understand them.
Pros and cons of investing in the Russell 2000
Investing in an index ETF that tracks the Russell 2000 has both pros and cons like any other investment.
Investing in a passive ETF that tracks this index means that you will be getting pure exposure to this segment of the U.S. stock market.
An ETF that tracks this index will provide style purity. You know that you are investing in an ETF that falls into the small blend asset class.
The two main ETFs that track this index, the ishares and the Vanguard funds, both offer low expense ratios.
Both of these index ETFs are widely traded, and the spread between the bid and ask prices is negligible. This means that there won’t be a significant variation between the price quoted and what a buyer will pay for the shares you might be selling.
This is a widely followed and traded index, there should never be any issues with the liquidity of the ETF.
Investing in a Russell 2000 index product does not constitute a diversified portfolio for most investors. It can be a segment of a well-diversified portfolio.
The index is market cap weighted and can reflect the performance of just a few holdings in extreme cases.
Small caps in general can be risky. A fund of 2,000 stocks mitigates some of this individual company risk, but as a whole small cap stocks are riskier than large blue chips.
Alternatives to the Russell 2000
For those who want to invest in small cap stocks, there are alternatives to investing in a fund or ETF that uses the Russell 2000 as a benchmark.
ETF.com lists 123 small cap ETFs on their site. This encompasses a wide range of funds, here are some highlights:
ishares Core S&P Small Cap ETF (ticker IJR) tracks the market cap weighted S&P 600 index. The index has few stocks and inclusion is more selective than with the Russell 2000. The Russell index simply takes the smallest 2,000 stocks by market cap of the Russell 3000 Index. S&P uses criteria such as positive net income for the prior 12 months and for the most recent quarter. A certain percentage of the company’s stock must be publicly traded as well. The performance numbers show this higher quality. Over the 10 years ending July 31, 2019, the S&P 600 ETF had an average annual return of 13.95% comped to the ishares Russell 2000 ETF’s return of 12.50%.
ishares also offers two ETFs, ishares Russell 2000 Growth ETF (ticker IWO) and ishares Russell 2000 Value ETF (ticker IWN) that invest in the portions of the Russell 2000 index that are classified as growth and value. The stocks included in each fund track the Russell 2000 Growth and Russell 2000 Value indexes, respectively.
There are a number of other small cap ETFs that track indexes that seek to rival the Russell 2000 index and are offered by ETF issuers like Charles Schwab, State Street Global Advisors (the SPDR ETFs) and many others.
Beyond ETFs there are many mutual funds that invest in small cap U.S. stocks. The mutual funds are both index funds and actively managed funds. Actively managed fund managers select the stocks to hold in the fund and don’t track a benchmark index like the Russell 2000. Actively managed funds are generally more expensive in terms of their fees and expenses.
Investors can also select individual stocks that would be classified as small caps on their own. This is generally riskier than using a pooled investment vehicle like an ETF or mutual fund where there are a number stocks held, so that if one doesn’t pan out in terms of performance the investor is protected by the ETF’s diversification.
Investing in small cap stocks, whether through an ETF that tracks the Russell 2000, one that tracks a different small cap index or via another method can be part of a diversified portfolio. It’s important for investors to take a close look at their investing goals including their time horizon for the money and their tolerance for risk in developing an asset allocation for their investment portfolio.
Many people choose to invest with a robo-advisor because it allows for further diversification. A robo-advisor can help you determine what your overall asset allocation should be based upon your situation. You just take a short survey to determine your goals and risk tolerance before a personalized portfolio is built for you.
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