Small-cap index investing works, just don't do it with the Russell 2000.

fundcoverage@morningstar.comIWM
by Alex Bryan
7/1/2019
iShares Russell 2000 ETF

IShares Russell 2000 ETF IWM is a fine offering with a durable cost advantage against its actively managed peers, but there are better alternatives and cheaper funds that track the same index. It earns a Morningstar Analyst Rating of Bronze.

The fund tracks the Russell 2000 Index, which targets the 1,001st to 3,000th largest U.S. stocks and weights them by market capitalization. This approach effectively harnesses the market's collective wisdom and is laudably objective and transparent. As one of the oldest small-cap indexes, the Russell 2000 has become the default benchmark for many small-blend active managers. Yet, this index has been an easier benchmark to beat than many other small-cap indexes, which makes it less appealing to track. Over the trailing 10 years through May 2019, it lagged the S&P SmallCap 600 and CRSP U.S. Small Cap indexes by more than 1.4% annually.

The Russell 2000 Index's popularity can help explain its underperformance. Because there is a lot of money tied to this index, there is considerable price pressure when stocks are added to or removed from the index. Prices get bid up when new constituents are added and pushed down when stocks are removed, which can hurt the index's performance. This issue is exacerbated by the Russell 2000 Index's reach further down the market-cap ladder than some of its peers, and its smaller float requirement, which gives it greater exposure to thinly traded stocks, where the market impact cost of trading can be high.

The index does not take adequate steps to address this issue. It does not have any buffers to mitigate unnecessary turnover along its lower market-cap bound, where transaction costs tend to be the greatest. So, if a stock in the index falls even slightly below the size of the 3,000th largest U.S. stock, it gets booted from the index. And the index concentrates those changes on a single day each year, rather than gradually moving stocks in or out, which can increase price pressure. The managers of this fund have the flexibility to trade ahead of index changes to get better prices, but their primary goal is to mitigate index-tracking error.



Portfolio Construction

This broad market-cap-weighted strategy effectively diversifies risk and harnesses the market's collective wisdom. However, it will likely suffer from a larger rebalancing drag than other small-cap indexes. It could use buffering rules to reduce unnecessary turnover among its smallest holdings and increase its constituents' liquidity requirements. It earns a Neutral Process Pillar rating. The fund tracks the Russell 2000 Index, which represents the stocks ranked 1,001 to 3,000 by market cap in the Russell 3000 Index. Because this is one of the most popular small-cap indexes, there's a lot of money tracking it. This means that market participants simultaneously demand liquidity from stocks that are added or removed from the index. Most small-cap indexes use buffering rules to reduce turnover that doesn't significantly affect the portfolio. This index only applies a modest buffer to reduce turnover between the Russell 1000 and Russell 2000 indexes but doesn't apply a similar buffer to reduce trading among its smallest holdings. Only 5% of a stock's shares must publicly trade for it to be included in the index. Most other index funds require at least double that percentage. This inclusion of less liquid stocks and absence of rules to reduce unnecessary trades increases the fund's transaction costs. The index reconstitutes in late June each year.

Fees

BlackRock charges an annual fee of 0.19% for this fund, which is cheap in the Morningstar Category, but there are cheaper funds available. It earns a Positive Price Pillar rating. During the trailing three years through May 2019, the fund lagged its benchmark by 1 basis point per year. The fund has been able to more than offset some of the drag created by its fee through a combination of savvy portfolio management techniques and securities lending.

S&P 500 index data: S&P 500 Copyright @ 2019

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