IJR: Examining The Attractiveness Of Small Caps (NYSEARCA:IJR)

Thesis

Generally recognized among finance practitioners and examined in this analysis, the size-factor effect refers to the empirical observation that mid-and small-cap stocks (market cap between $2B and $10B) outperform the broader stock market (large cap equities) over long periods of time. IJR represents a popular and effective option for investors looking to gain exposure in the space. As I discuss in this analysis, it also, currently, presents investors with an attractive value proposition.

A Bad Time For The Markets

The turbulent ride markets have been on for the past 6-month period has been particularly bad for small caps. Along with the technology sector, small-caps are experiencing a deeper drawdown than the broader market, retreating by 12.63% over the past year and 18% YTD. Rising rates, inflation and an unstable macroeconomic environment spread fear among investors, and as small caps are generally viewed as more risky, the selling pressures are mounting.

ETF Structure & Attributes

iShares Trust – iShares Core S&P Small-Cap ETF (NYSEARCA:IJR) is managed by BlackRock Fund Advisors and seeks to track the performance of the S&P Small-Cap 600 Index. The fund includes both value and growth stocks in the small-cap space. With over $64B in Assets Under Management (“AUM”), IJR is the most popular ETF in the space.

The primary case for IJR, in my view, today lies in the relative valuation of small-caps. As shown in the table below, which contains a few significant metrics and facts for a group of popular ETFs, IJR offers the most attractive valuation. It trades at 13.2x P/E and 1.73x P/B. The fund is undervalued both in terms of its own historic average valuation multiples and compared to large-cap, mid-cap, growth, and value factor funds.

IJR also offers a marginally better dividend yield than both the S&P 500 and the mid-cap ETFs IJR, IVV, and IJH (1.67% vs. 1.43% vs. 1.42%, respectively). If fact, the only fund in the group that offers a higher yield is the value-factor ETF (IWD).

It is often said how the broader market has become overly weighted towards technology stocks, and, therefore, sensitive to aggressive downside moves, like the one the market is currently experiencing, or the infamous tech bubble in the late 90s. Indexes tracking small-caps are usually less tech-friendly and offer investors another shot at diversification, in a market where it often seems unattainable. IJR is considerably more favorable to financials, industrials, and real estate than an S&P 500 ETF like iShares’ IVV, while at the same time providing limited exposure to Technology and Communication stocks. A comparison between IVV’s and IJR’s sector exposures is available in the table below.

Backtesting the Size factor

After establishing the case for the small-cap trade, and IJR specifically, it is prudent to examine how the size factor has performed over a prolonged period of time, both in terms of returns and risk. Moreover, we examine how and if adding a small-cap ETF like IJR to a portfolio could affect an investment’s overall returns and risk profile. To that end, I employed the valuable tools offered by portfolio visualizer.

Going all the way back to 1972, I constructed and backtested the performance of 3 different portfolios, all with different allocations across 3 asset classes. The first portfolio represents an investment solely on the broader U.S stock market (think of an S&P 500 or a Russel 1000 ETF), and is, as a result, heavily weighted toward large-cap equities. From there, the mid-cap and small-cap factors are added, with a 25% weighting each in the second portfolio, and 30% for the third.

As the simulation provided in the graph below shows, the addition of mid-cap and small-cap equities improves the overall performance of the portfolio. More specifically, by solely investing in the market, an initial $10,000 investment would have yielded $1,535,503 (10.52% CAGR) over the 45+ years term, versus the $2,105,983 (11.21% CAGR) a 25% exposure in small caps and mid caps would have resulted in. By increasing the size-factor exposure even more, at 30% for small-caps and mid-caps respectively, the overall performance is somewhat improving to $2,227,540 (11.34% CAGR).

As any seasoned investor would expect, what may appear as a small increase on an annualized rate basis can delivers drastically different results over the time span of the backrest, exploiting the power of the compounding effect.

On a risk basis, small and mid-cap additions, as expected, raise the volatility profile of the portfolios. The market portfolio carries a 15.62% standard deviation and -50,89% maximum drawdown, while the 60%-30%-30% portfolio carries the highest standard deviation of 16.97% and maximum drawdown of -52.44%. That said on a risk-adjusted returns basis, as measured by the Sharpe ratio, both portfolios incorporating small and mid-cap exposure outperform( 0.46 vs 0.43). They also exhibit significantly higher returns during their respective best-performing years.

For a more in-depth look into annualized returns and standard deviations across the three portfolios, the table provided below might prove to be useful. While the performance statistics above are important, in order to understand the historical size-factor effect, many investors are interested in a more medium-term approach.

Over the last 10 and 5-year periods, the analysis’ results seem inverted. More small and mid-cap exposure has resulted in decreases in relative performance, as for the last decade, the bull market has been spearheaded by large-caps, mainly in the technology and consumer discretionary sector. Comparatively, small caps display poor return performance and elevated volatility and have, as result, lost favorability for many investors. If anything is to be said, however, I believe this further highlights the gap in valuations (discussed previously) between large and small caps and the attractive risk-reward equation currently presented.

Final Thoughts

After all things are considered, the small-cap space offers an attractive value opportunity for long-term-oriented investors. The valuation discount of small caps is likely to fade over time, and IJR represents a historically reliable source of alpha for an otherwise well-diversified portfolio.