IJS ETF: Seeking Value In Small Caps (NYSEARCA:IJS)

Strategy and portfolio

The iShares S&P Small-Cap 600 Value ETF (NYSEARCA:IJS) has been tracking the S&P SmallCap 600 Value Index since July 2000. Its distribution yield is 1.60% and its total expense ratio is 0.18%. It is a direct competitor of the SPDR S&P 600 SmallCap Value ETF (SLYV) and the Vanguard S&P Small-Cap 600 Value Index Fund (VIOV), which track the same underlying index and have a similar expense ratio (0.15%).

As described by S&P Dow Jones Indices, S&P 600 constituents are ranked in Value and Growth styles using three valuation ratios and three growth metrics. The valuation ratios are book value to price, earnings to price and sales to price. By construction, 33% of the parent index constituents exclusively belongs to each style, and 34% belongs to both styles. The Value subset serves as S&P 600 Value Index and is rebalanced annually. It is capital-weighted, with an adjustment for constituents belonging to both styles. For example, a company with a Value rank better than its Growth rank is given a larger weight in the Value Index than in the Growth Index.

As expected, aggregate valuation ratios of IJS are lower than for the iShares Core S&P Small-Cap ETF (IJR), which tracks the S&P SmallCap 600 and may be used as a benchmark. The difference is significant in price/book, but moderate in other ratios:

Source: Fidelity

IJS has over 500 holdings: mostly stocks of course, but also swaps and cash equivalents. The top 10 names represent 7.4% of the portfolio value. The next table lists their weights and valuation ratios. The largest one weighs about 1%, so the risk related to any individual stock is low.

Ratios: Portfolio123

The heaviest sectors are financials (20.1%), industrials (17.5%) and consumer discretionary (12%). Other sectors are below 10%. Compared to the small-cap benchmark, IJS underweights technology and healthcare. It slightly overweights financials, industrials, materials and energy. The difference in other sectors is not significant.

Since inception (07/24/2000), IJS is very close to the parent index in performance and risk metrics.

Data calculated with Portfolio123

Comparison with my Dashboard List model

The Dashboard List is a list of 80 stocks in the S&P 1500 index, updated every month based on a simple quantitative methodology. All stocks in the Dashboard List are cheaper than their respective industry median in Price/Earnings, Price/Sales and Price/Free Cash Flow. After this filter, the 10 companies with the highest Return on Equity in every sector are kept in the list. Some sectors are grouped together: energy with materials, communication with technology. Real estate is excluded because these valuation metrics don’t work well in this sector. I have been updating the Dashboard List every month on Seeking Alpha since December 2015, first in free-access articles, then in Quantitative Risk & Value.

The next table compares IJS underlying index since inception with the Dashboard List model, with a tweak: the list is reconstituted annually instead of once a month to make it comparable to a passive index.

Past performance is not a guarantee of future returns. Data Source: Portfolio123

The Dashboard List outperforms the S&P 600 Value Index by 2.35 percentage points in annualized return and has slightly better risk metrics (drawdown and volatility). However, IJS price history is real and the model performance is hypothetical.

I like the idea of mixing the size factor with various ratios to rank value stocks like IJS index does. The price/book ratio (P/B) is the historical value factor from the Fama-French three-factor model. However, statistics in the last two decades show that it may add some risk in the strategy. A large portfolio of companies with low P/B is likely to hold a higher percentage of value traps than a same-size group with low price/free cash flow. It is also likely to show higher volatility and deeper drawdowns. The next table shows the return and risk metrics of the cheapest quarter of the S&P 500 (i.e. 125 stocks) measured in price/book, price/earnings, price/sales and price/free cash flow. The sets are reconstituted annually between 1/1/1999 and 4/20/2021 with elements in equal weight.

Data calculated with Portfolio123

This explains my choice of using P/E, P/S, P/FCF, but not P/B in the Dashboard List model.

I think IJS underlying index has another shortcoming: classifying all stocks on the same criteria. It means the valuation ratios are considered comparable across sectors. Obviously they are not: you can read my monthly dashboard here for more details about this topic. A consequence is to privilege sectors where valuation ratios are naturally cheaper, especially financials. Some other sectors are disadvantaged: those with large intangible assets like technology. Companies with large intangible assets are those with a business model based on massive R&D, or a strong branding, or large user databases, or operating in a field where competition is limited by an expensive entry ticket. All these elements are not correctly reflected by valuation ratios.

Takeaway

IJS implements a strategy based on various value and growth metrics to classify S&P 600 stocks in value and growth categories, then invests in the value part. It has the same underlying index as VIOV and SLYV. IJS is a better instrument than its competitors for trading purposes thanks to a higher liquidity: the bid-ask spread and the slippage risk are smaller. Historical return and risk metrics of IJS underlying index are very close to those of the S&P SmallCap 600. IJS may be part of a tactical allocation strategy switching between value and growth depending on market conditions. However, it doesn’t meet expectations of bringing added value to its parent index. In my opinion, there are two flaws in its strategy: it ranks stocks regardless of their sectors, and using price/book as a primary factor increases the risk of catching value traps. An efficient value model should compare stocks in comparable sets (sector, industry), like I do in the Dashboard List since 2015. This model also uses three valuation metrics, excluding price/book. Moreover, a simple ROE rule helps filter out some value traps and normalize the number of components.