Evaluating Funds Part 3: No Small Returns With Small Caps

Never forget these two axioms:

Money frees us, but its pursuit may enslave us.

It’s not how much you have at the end; it’s how much you could have made.

The hunt for better/higher returns while still index investing continues apace (NIce SAT word, nerd!). Since we had already discussed S&P 500 (ie. large cap) index investing and mid cap index investing in earlier posts, we now can turn our attention and focus on to the last group (more or less…more on that later) of companies for index investing.

Small cap index investing here we come…

The same principle regarding mid cap index  funds remains true for small cap index funds. Despite the fear of being called an egoist for quoting myself, here is what I said in the last post “Think of the smaller companies out there that will eventually grow bigger and may become large caps over time. Who wouldn’t want to capture the (possibly) double digit growth year after year of such companies? And rather than hunt for these companies yourself spending dozens to hundreds of hours of research, there’s a far more efficient (both in time and cost—material and opportunity) way to steer some of this growth into your long term portfolio.”

Before we delve into the world of small caps, it should be noted what is unique about small caps compared to mid caps and large caps. Here is the best summary I could find of both the risks and rewards embedded in small cap companies and their associated funds:

Small caps are unique in that they are highly leveraged to the economy. These companies have smaller balance sheets and are more exposed to the economic cycle. During recessions, many may go bankrupt. This is in contrast to mid-cap and large-cap companies that have more established operations and reserves to get through and thrive during turbulent times.

For these reasons, small caps are considered a leading indicator for the economy. When traders become enthused about prospects for economic growth, they move into small caps. When they are worried about a slowdown, they start to sell small caps first.”

So, assess and then re-assess your risk tolerance before you plunge in.

But, if you’re ready for a higher risk/higher reward investment.

So let’s dig into the small cap index funds that are available:

  1. Vanguard Small Cap ETF (VB) traded at $143.73 as of the end of 1/24/19. The ten year return has been 13.62% annually on average. (This translates to $10,000 being invested in 2008 growing to $35,713.03 today.) There is a dividend (always greatly appreciated) of 1.77%.The expense ratio is a highly favorable 0.05% (meaning $5 per $10,000 invested) just like the mid cap funds. Of note, there is a no minimum initial investment to be invested in this fund.
  2. Vanguard Small Cap Index Fund Admiral Shares (VSMAX) traded at $68.87 as of the end of 1/24/19. The ten year return has been 13.57% annually on average. (This translates to $10,000 being invested in 2008 growing to $35,712.57 today.) There is a dividend (still and always greatly appreciated) of 1.8%.The expense ratio is also a highly favorable 0.05% (meaning $5 per $10,000 invested). Of note, this fund requires a $3,000 minimum initial investment after which any amount of  money can be invested in the fund.
  3. iShares Russell 2000 ETF (IWM) traded at $147.34 as of the end of 1/25/19. The ten year return has been 11.99% annually on average. (This translates to $10,000 being invested in 2008 growing to $39,887.47 today.) There is a dividend (still and always greatly appreciated) of 1.40%.The expense ratio is 0.19% (meaning only $19 per $10,000 invested, but it is 400% more expensive than the Vanguard funds). There is no minimum initial investment for this fund.
  4. Vanguard Russell 2000 ETF (VTWO) traded at $118.33 as of the end of 1/25/19. The return has been 10.30% annually on average since 9/20/10 (the inception date of the fund), but only 4.44% over the past five years. (This translates to $10,000 being invested on 9/20/10 growing to $22,531.62 today.) There is a dividend (still and always greatly appreciated) of 1.44%.The expense ratio is 0.15% (meaning only $15 per $10,000 invested, but it is 300% more expensive than the other Vanguard funds). There is no minimum initial investment for this fund.
  5. SPDR S&P 600 Small Cap ETF (SLY)  traded at $65.54 as of the end of 1/25/19. The ten year return has been 14.93% annually on average. (This translates to $10,000 being invested ten years ago growing to $40,210.00 today.) There is a dividend (always greatly appreciated) of 1.43%.The expense ratio is 0.15% (meaning only $15 per $10,000 invested, but it is 300% more expensive than the Vanguard funds). There is no minimum initial investment for this fund.

Once again for the sake of comparison:

“When comparing the above returns to what the S&P 500 would have done by itself, keep in mind that the average total return for the S&P 500 dating from January 2008-December 2018 was 7.185%. (This improves dramatically to 12.603% if you started putting the money at the end of 2008 in December of that year after the financial crisis had hit fully and the market had already sunk significantly with more to come until it hit bottom in March 2009.)”  

Sarcastic Reader: Man, this guy just can’t stop quoting himself like he’s Oscar Wilde or something. What an egoist!

So there’s quite a few choices as you can see. The first two Vanguard funds (VB, VSMAX) are the cheapest ad have performed well.

IWM has performed as well as these Vanguard funds, but is four times as expensive for that same performance. Same performance is the minimum requisite of an index fund, but it shouldn’t be much more expensive than others for that same performance.

So..nah for IWM.

The Vanguard Russell 2000 ETF is not an option as it has performed poorly regardless of cost—which, by the way, is still three times more than the VB or VSMAX thus making it a two time loser.

Sorry, but bye bye, Vanguard Russell 2000 ETF.

That leaves SLY which is still three times more expensive, but has performed the best of all of these small cap funds by over one percent over the past ten years.

So it appears we have VB/VSMAX versus SLY for your best small cap index fund.

Now, we get down to splitting hairs.

Assume a few things first:

You don’t have an array of Vanguard or SPDR funds. If you do, then stop and just go with the fund that matches up with what you already have.

There is no exact right answer here, but more of a way to think about what you’re seeking in an investment. If you’re worried about the future performance of the any of the funds more than anything else, then pick the cheapest fund(s)—VB/VSMAX. This lets you control the only thing you can (the fees) with the realization of what you cannot—the big bad market.

If you’re confident that you will ALWAYS outperform the cheaper funds, then go for the gusto. Personally, I like the security of cheaper funds (control what you can control to your advantage) rather than hoping everything keeps coming up roses…because you know it won’t—there will be down years. You just don’t know when. ALWAYS is rarely a good option both on med school and Board exams; the same holds true for the market.

Let’s hold here for now.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Please spread the word about this blog to your friends (real and virtual), family, and colleagues. Talk to you soon.

Until next time…