IJS: Not The Best Option In This Space, But Still Offers Some Promise

Introduction

The iShares S&P Small-Cap 600 Value ETF (NYSEARCA:IJS), a stalwart that has been around since the turn of the millennium, offers coverage to US small-cap stocks that are believed to be undervalued. To expand on this, IJS’s tracking index focuses on the stocks from the S&P Small-Cap 600 Index that exhibit the strongest value traits. To ascertain this, the ETF seeks to allot composite value scores to stocks from the underlying universe, based on three key sub-metrics; a) the earnings yield, b) book value to price, and c) sales yield.

So, as per these gauges, IJS has currently managed to construct a portfolio of 468 stocks, although that portfolio does tend to see quite a bit of churn annually (typically, over 1 in 2 stocks get turned over every year).

How Good Is IJS?

So, is IJS any good? Well, to answer that question with more context, we thought it would be pertinent to stack it up against the largest small-cap value ETF – the Vanguard Small-Cap Value Index Fund ETF (VBR), which has managed to accumulate an AUM figure that is almost 8x) as much as IJS, despite coming to the bourses only 4 years later ($52bn as opposed to less than $7bn for IJS).

VBR’s popularity may in large part be driven by its more cost-efficient and stable structure. Its expense ratio of 0.07% is one of the cheapest around, and 11bps lower than IJS. Note that investors also get access to a much wider pool of names (859 stocks), which doesn’t necessitate the need to indulge in frequent churn every year. Indeed, VBR’s annual portfolio turnover rate of just 16%, is more than 3x lower than IJS’s corresponding figure and its consistency and relative tax efficiency may be appreciated by a lot of other investors.

IJS also comes up short on the income angle front, where its current yield of 1.50% is well over 50bps lower than VBR. Note that this has been a recurring theme across the last 4 years, with the 4-year average yield difference between the two products also working out to roughly 50bps.

Then, when it comes to IJS’s historical track record, investors can certainly feel a tad disappointed. Both products have delivered handsome returns since VBR got listed in 2004, but IJS has lagged the former by 47bps.

When you dabble with the small-cap arena, you’re inherently getting wedged with stocks that generally have a higher risk profile, so it pays to minimize risk to the best extent possible. In that regard, IJS’s rolling volatility profile doesn’t fill one with a great deal of confidence, as it is roughly 500bps higher.

Note also that IJS hasn’t been able to showcase a compelling risk-adjusted return track record (relative to VBR) either in the long-run or the short-run. The Sharpe ratio chart highlights how well these products have managed to generate excess returns in the face of total risk taken, and here note that VBR has thrown up better numbers both over a 15-year time frame and a 5-year time frame.

The Sortino ratio looks at excess return abilities, only in the face of harmful volatility, and here too IJS hasn’t quite been able to trump VBR, regardless of the time frame in question.

All in all, given that it lags VBR on most fronts, we don’t feel that IJS is the most appropriate product to exploit conditions in small-cap value.

Closing Thoughts – A Few Reasons To Consider IJS Despite Its Relative Inferiority To VBR

As noted in the previous section, IJS is not as compelling as VBR, but if you’re still keen to pursue this product, here are a few encouraging themes worth noting.

Small-caps haven’t quite been able to flourish in recent periods, as the Fed’s stance with rate cuts keeps getting delayed. Small-caps are more vulnerable to a weakness in a high-interest rate regime, firstly because they are more financially geared than their large-cap peers. For context, note that close to 40% of the debt, of the constituents of the Russell 2000 index (the prime benchmark for small-caps), is believed to be short term or floating rate debt; for large-caps, that share is only 9%, reiterating the disparity. This is one of the prime reasons why small-caps outperformance hasn’t quite taken place. However last week’s labor report was quite encouraging for the future trajectory of rates, as the non-farm payroll number of just 175k (the market was expecting 243k) was the lowest over the past 6 months, and also comes on the back of downward revisions in Feb and March. Wage growth too dropped below 4% for the first time in 3 years. All these developments are likely to provide the Fed with support to cut rates sooner than expected. Compared to a 54% probability of a 25bps cut in September, we now have an increased probability of 67% which would be music to the ears of these small-caps. Yes, September is still some way off, but you don’t want to buy small-caps after the rate cuts are announced but before they take place.

Secondly, note that these small-cap stocks, and more so, small-cap value stocks, are currently trading at some rather compelling valuations. As per Morningstar, IJS’s portfolio is priced at a P/E of just 12.63x, which translates to a 22% discount over the value stocks from the large-cap-based S&P500. At that cheaper multiple, small-cap value also offers better long-term earnings potential of 10.37% which is around 160bps more than IVE.

We also have a situation now where small-cap value stocks look like ripe candidates for mean-reversion relative to small-cap growth stocks. The image below showcases how the ratio of small-cap value to small-cap growth is currently around 20% off its long-term average.

Finally, also consider that IJS is dominated by financial stocks which account for 23% of the total holdings, and currently, within the small-cap value space, this cohort looks like one of the most oversold groups that could be due a comeback (the current RS ratio is around 30% off its long-term average).