SPDR® Russell 2000 US Small Cap ETF (LSE:R2US) - ETF price


ETF Report

SPDR® Russell 2000 US Small Cap UCITS ETF R2US

AnalystReport

PortfolioConstruction

The fund tracks the Russell 2000 Net Return Index, which represents about 8% of the US equity universe and consists of the smallest 2,000 companies in the Russell 3000 Index. The index applies limited buffering. New constituents are added if they rank between the 1,001th and 3,000th stock in the market-cap-weighted Russell 3000 Index. Existing constituents remain if they fall between a cumulative 5% of the market-cap breakpoint. If the stock has a market cap 2.5% higher than the size cutoff zone or 2.5% lower, it will then be moved to a different Russell market-cap index. The index also has a low liquidity hurdle for its holdings. Only 5% of a stock's shares must publicly trade for it to be included in the index. Including more-illiquid stocks without reducing unnecessary trades increases the fund's transaction costs. The index reconstitutes annually, although eligible IPOs are added quarterly. Russell's mechanical index inclusion rules lead to an unbiased portfolio that casts a wide net, capturing almost all small-cap stocks, but it can result in the inclusion of less-profitable companies. The index is well-diversified at the sector and security level. The biggest sector allocations are to financials, technology, healthcare, and industrials, at 15% to 20% each. The top 10 holdings account for only 3% of total index weightings.

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Fees

The fund levies an ongoing charge of 0.30%, making it one of cheaper options among US small-cap equity ETF peers. The five-year annualised tracking difference (fund returns less index returns) has been positive 0.33% for the period ended June 2019, indicating that the fund outperformed its benchmark. This outperformance can mainly be attributed to SPDR's optimisation process and withholding-tax differences between the fund and the index. The fund is domiciled in Ireland, which benefits from a double tax treaty with the United States. This enables the fund to enjoy a better withholding-tax rate on dividends compared with the Russell 2000 Net Total Return Index. Optimisation has been a source of tracking error. However, it will be reduced as the fund grows its size and moves towards full replication. Other costs potentially carried by the unitholder include bid-ask spreads and brokerage fees when buy and sell orders are placed for ETF shares.

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FundConstruction

The fund uses optimisation techniques to replicate the performance of the Russell 2000 Net Total Return Index. While this approach has undeniable cost advantages by virtue of excluding smaller, less-liquid components of the index, it creates a potential source of tracking error as the fund strays from perfectly mirroring its benchmark. That said, as the fund continues to grow, it will move toward full replication, which should reduce tracking error but also increase trading costs. The fund does not engage in securities lending but uses futures for equitisation purposes, which helps limit tracking error. After a few years with no clear strategy in Europe, SPDR seems to have gotten its act together. The company counts on a large pool of experienced professionals across asset classes and globally renowned as asset managers. Its most recent ETF efforts in Europe have paid off in terms of assets under management growth, but it still has plenty of catching up to do to bring the business up to the same competitive level it enjoys in the US. The strength of the brand and its very particular focus on benchmark research and selection could help it in this process.

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Suitability

This low-cost and well-diversified exchange-traded fund is likely to continue outperforming its Morningstar Category peers over the long haul. However, it tracks an index that is prone to higher transaction costs. This limits the fund’s Morningstar Analyst Rating at Bronze.

SPDR Russell 2000 US Small Cap ETF tracks the Russell 2000 Index, one of the most widely followed US small-cap indexes; it targets the smallest 2,000 stocks from the Russell 3000 Index.

Small-cap stocks are usually less-established and less-liquid names compared with large caps. This can lead to higher transaction costs when the portfolio is rebalanced. Most small-cap indexes apply buffer zones, allowing constituents to stay in the portfolio even if their market caps fall above or below target size thresholds. But the Russell 2000 Index applies very limited buffering criteria. Compounding the issue is the popularity of the Russell 2000 Index, which not only translates into higher demand for liquidity but also makes the index more susceptible to trading by arbitragers seeking to exploit index changes. Considering this, fully replicating the Russell 2000 Index tends to be expensive and inefficient.

SPDR has been able to mitigate higher transaction costs by using an optimisation process. Instead of holding 2,000 names, this fund only holds around 1,600 constituents. This approach has largely contributed to the fund's outperformance relative to its benchmark as well as peer ETFs that track the same index. As the fund size grows, it will move toward full replication, which should reduce tracking error but also increase transaction costs, which in turn will weigh on the fund's performance.

Despite this, we are confident about the ability of the fund to outpace its category peers in the long term on a risk-adjusted basis, aided by its competitive fee of 0.30%, which falls at the low-end among all US small-cap equity ETFs. The fund has beaten category peers since its inception in 2014, while other Russell 2000 ETFs with longer track records have fared equally well on a  risk-adjusted basis over 10-year period.

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Fundamental View

It is intuitive to presume that small-cap stocks should outperform their large-cap counterparts over the long run. After all, small caps do tend to have more-limited financial resources, weaker competitive advantages (if any), and lower profitability than large caps. They also tend to be more volatile and have less analyst coverage--which may increase the risk of mispricing. An efficient market should compensate investors for accepting greater nondiversifiable risk with higher expected returns.

Consistent with this view, US small-cap stocks historically have outpaced their large-cap counterparts over the long term. However, since the early 1980s, the small-cap premium has diminished despite outperformance during the past decade. Even if the premium still exists, it is unreliable at best. Investors should not count on a small-cap tilt to boost long-term performance. That said, small caps have historically been seen as providing some diversification benefits to an investment portfolio.

Stocks in the Russell 2000 Index are only screened by size (unlike its rival S&P SmallCap 600 Index, which in addition applies a profitability filter). In that regard, the fund is purely passive.

Because of its popularity, the Russell index may be more susceptible to trading by arbitragers seeking to exploit index changes relative to other small-cap indexes. When these arbitragers trade ahead of the index, they can hurt the index's performance by pushing up the prices of the stocks that it is set to add and by depressing the prices of the stocks that it is slated to trim.

In terms of performance, the Russell 2000 Index has trailed the S&P SmallCap 600 Index benchmark by approximately 1.3% per year during the past five years ended June 2019. The latter enjoys a slight quality tilt thanks to its profitability filter and fewer assets are benchmarked to it.

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Alternatives

There are other providers offering exposure to the Russell 2000 Index, including Amundi, Invesco, L&G, Lyxor, and Xtrackers. Ongoing charges range from 0.19% to 0.45% with Lyxor being the cheapest option.

As an alternative, investors seeking exposure to the US small-cap equity market could also look to ETFs tracking the MSCI USA Small Cap or the S&P SmallCap 600 indexes. The MSCI USA Small Cap Index represents approximately 14% of the US equity market and contains around 1,800 members and IShares MSCI USA Small Cap (0.43% ongoing charge) is the only option. As for the S&P SmallCap 600 Index, Invesco offers an ETF with an ongoing charge of 0.14%, which is the lowest in the category.

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