Small-Cap ETFs See Strong Inflows: Here's What You Need to Know

Small-cap ETF data

If you haven't explored it yet, ETF Central offers various "segments" that correspond to different parts of the market. The segment we're watching closely right now is "U.S. Small Cap ETFs," which currently consists of 41 total ETFs. On the segment page, you can view performance and fund flow data.

So far, domestic small-cap returns have lagged the broad market year-to-date, but fund flows have been unusually robust, taking in $11.52 billion since the start of the year. Notably, over half of this inflow came within the one-month period ending July 22, amounting to $6.44 billion.

The ETF Central segment data also shows one-week inflows by ETF. Unsurprisingly, the bulk of five-day small-cap ETF inflows have come from just one ETF: the iShares Russell 2000 ETF

, which tracks the most dominant small-cap index.

Which ETFs to watch?

Russell 2000 ETFs like IWM are excellent for short-term trading within the U.S. small-cap segment due to their strong liquidity. They offer a minuscule bid-ask spread and one of the best ETF options chains out there with numerous strikes and expiry dates.

However, as a buy-and-hold investment, I personally find them suboptimal. This has nothing to do with the ETF itself but everything to do with the index it tracks.

The Russell 2000 Index, by nature, aims to be broad, capturing a vast array of small-cap stocks. This breadth, however, includes a significant amount of what I call "junk"—unprofitable small caps with poor financial health – think your average penny stock.

The Russell 2000 index pretty much includes any domestic small cap stock with sufficient daily volume and public float size. Additionally, its predictable annual reconstitution has drawn criticism for being easy to front-run. To alleviate this, I prefer the competing S&P SmallCap 600 Index, which has a profitability screener in place.

This index requires the sum of the most recent four consecutive quarters' earnings to be positive, with the most recent quarter's earnings also needing to be positive. The S&P committee process further refines the index by adding or dropping constituents as needed.

As seen below, the iShares Core S&P Small-Cap ETF

has markedly outperformed IWM from 2000 to the present on both total and risk-adjusted returns:

Conveniently enough, IJR is significantly cheaper with a 0.06% expense ratio compared to IWM's 0.19%. Finally, given that it uses a different index, IJR can also be utilized as a viable tax-loss harvesting partner for IWM.

 

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.