IJR: Some Enticing Underlying Themes (NYSEARCA:IJR)

ETF Profile

Investors on the lookout for low-cost, small-cap oriented investment vehicles may consider dabbling with the iShares Core S&P Small-Cap ETF (NYSEARCA:IJR). With close to $70bn in AUM accumulated over 23 years, IJR comes across as the most popular ETF in this space.

With a lowly expense ratio of just 0.06%, it’s easy to see why investors gravitate to this name. Besides, despite offering access to around 600 stocks, this isn’t a portfolio that is subject to an awful lot of churn annually. For context, last year, the annual turnover ratio of IJR only came in at 19%, meaning less than 1 in 5 stocks got rotated out. Conversely, for most other ETFs, one typically sees 1 in 3 stocks getting rotated out every year. This relative stability of IJR can be a rather attractive draw for buy-and-hold type investors, looking to benefit from constant exposure through various cycles.

From an income perspective, IJR’s yield of 1.59% may not come across as too compelling, when you know that the median yield of all ETFs is around 80bps better. Yet, it’s also worth considering that the growth rate of IJR’s dividends over the last 3 (12%) and 5 years (8%) has been considerably better than what other ETFs have seen (6.4-7%).

IJR vs. its biggest peer – IWM

After IJR, the second-largest ETF in the US small-cap space is the iShares Russell 2000 ETF (IWM) with $53bn in AUM. In fact some would say that IWM is even more popular than IJR, given the hefty degree of dollar volumes witnessed in that counter on a daily basis. For further clarity note that IWM witnesses dollar volumes to the tune of over $5.5bn a day, whereas IJR’s corresponding figure is a fraction of that, at less than $0.4bn a day.

For the uninitiated, even though both are small-cap plays, they both track different indices. IJR tracks the S&P Small-cap 600 Index, whereas IWM tracks the Russell 2000 Index. As implied by the respective names of those tracking indices, IJR covers a much smaller pool of names, whereas IWM spreads its tentacles over a larger group of stocks. However, as we’ll highlight soon enough, covering a larger pool of stocks doesn’t necessarily offer a great deal of merit.

Interestingly enough, both products began life on the bourses on the very same day (May 22nd, 2000), so a comparative analysis of the return and risk profile of the two would be rather apt.

Firstly, do consider that from a total return angle, IJR has comfortably trounced IWM by 1.63x.

It isn’t just the degree of absolute returns that are worth admiring. IJR also has a slightly lower risk profile (as exemplified by the differential in the annualized standard deviation of monthly returns of the two products).

Also, for the degree of per unit risk that IJR takes, the level of excess return (over the risk-free rate) that IJR generates is around 900bps superior (note the respective Sharpe ratios).

Finally, you also want to consider how these ETFs fare during environments of hostile volatility, and even here, note that IJR’s Sortino ratio is a lot superior to IWM’s associated figure.

If one compares the respective average market-cap of both these products, it looks like, within the broad small-cap universe, IJR gives a little more emphasis towards micro-cap names. Indeed, data from Morningstar shows that IJR’s micro-cap share stands at 40.5%, around 320bps more than IWM’s associated exposure. It speaks to the S&P Small-cap 600 Index’s superior stock picking and risk management capabilities that despite engaging with the riskier side of the market (at least in theory, micro-caps are inherently more volatile), it is still able to maintain a relatively lower total risk profile than IWM.

We believe it helps that during the screening process, prospective stocks that could make it to the S&P Small-cap 600 Index are also screened to ascertain if they are financially viable (basically, these companies are required to have positive reported EPS in the most recent quarter and the 4 most recent quarters in aggregate). This could help in weeding out some of the risky zombie micro-caps.

Closing Thoughts – Is IJR A Good Buy Now?

Based on the developments on IJR’s weekly chart (which we’ll come to later), we are not entirely convinced that now is the best time to get into IJR. Having said that we still see a lot of encouraging themes.

Firstly, there’s the superior value differential relative to large caps. The S&P500 is currently priced at 20.5x P/E which represents a 47% premium over IJR’s corresponding multiple. Such a vast differential may have been acceptable if SPY’s holdings were poised to deliver far superior earnings growth, but that is not the case. In fact IJR’s holdings are poised to deliver weighted average long-term earnings of 11.8%, around 120bps higher than what its larger peers are expected to deliver.

Also look at how IJR is positioned relative to SPY. At the start of the year, there was no great incentive to rotate into IJR or SPY as the ratio was at the mid-point of its long-term range, but now it is around 13% off the mid-point and could benefit from some mean-reversion, which would reflect well on IJR bulls.

Also consider that IJR’s largest sector exposure is towards the financials segment, and the image below highlights how oversold small-cap financials look relative to the broad small-cap universe. Once again, this is another intriguing pocket that could benefit from some mean-reversion.

However, if we switch over to IJR’s weekly chart, we can see that it is currently going through a bout of volatility contraction, which is captured by a symmetrical triangle pattern. An entry at this stage would represent a sub-optimal reward-to-risk of less than 1x. Rather we think a pullback closer to the $92 level would represent a more suitable entry zone.