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The S&P 500 (SPY) is enjoying another huge year. As I write this, the large-cap index is up 27% year-to-date with the FAAMG+Tesla names leading the way. Things haven't been quite so positive for small-cap investors though. Despite a continuing economic recovery from the 2020 COVID recession, the Russell 2000 has gained just 12% this year. That's quite simply a huge underperformance that suggests investors aren't quite as bullish on equities outside of the big 5 or 6 names.

The story within small-caps, however, is more interesting. The S&P 500 Growth index has outperformed the S&P 500 Value index by a 32% to 22% margin, but it's been the reverse for small-caps. The Russell 2000 Value index has beaten the Russell 2000 Growth index 25% to 1%. Small-cap value has been the worst-performing style box for the last decade, so it's not surprising to see this group stage a comeback during the cyclical-led portion of the recovery earlier this year.

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The lagging performance of small-caps overall, however, should be a red flag. In a true economic expansion, you'd expect to see small-caps and other riskier asset classes outperforming. Instead, we've seen small-caps lagging throughout the year. This has mostly been a mega-cap growth and tech fueled rally. Lately, it's been the tech sector almost entirely leading the market higher, which generally isn't a good sign for sustainability.

The monetary environment might also work as a headwind for the sector in 2022. As I've said many times in recent months, entering a period of economic slowdown coupled with the launch of Fed tightening policy is generally a poor time to be invested in equities. Stocks may continue to push higher in the early stages, but tighter conditions tend to lead to equity underperformance eventually. In fact, it frequently ends with a recession or even a tail risk event, such as the tech bubble or the financial crisis. That's not to say something to that extreme will happen again, but the historical odds favor a coming period of low returns. If stocks, in general, underperform, expect small-caps to lag further.

That doesn't mean investors should abandon small-caps altogether. They are a great diversifier, obviously, and you need some of that growth potential in your portfolio. Plus, equities responded quite favorably to this past week's Fed meeting outcome, so we could have a fairly clear path to positive equity returns over the next few months. The universe of small-cap ETFs available to investors is large - almost 140 in total.

Ranking The Small Cap ETFs

The variety of ETF choices makes distinguishing the best from the rest a little challenging. You've probably heard most financial pundits talk about focusing on funds with low expense ratios. That can certainly be a big factor in deciding which ETF to go with (it's probably the most important factor, in my view), but there are a lot of things that could go into making the right choice.

That's where I'm going to try to make things easier for you. Using a methodology that I've developed, which takes into account many of the factors that should be considered and weighting them according to their perceived level of importance, we can rank the universe of available ETFs in order to help identify the best of the best for your portfolio.

Now, this certainly won't be a perfect ranking. The data, of course, will be objective, but judging what's more important is very subjective. I'm simply going off of my years of experience in the ETF space in helping investors craft smart, cost-efficient portfolios.

Methodology And Factors For Ranking ETFs

Before we dive in, let's establish a few ground rules.

First, all of the data is used is coming from ETF Action. They have gone through the ETF universe to identify and categorize those ETFs used here. There are many that qualify and we'll be using their categorization as a starting point. Many thanks to them for opening up their vast database for my use.

Second, let's run down the factors I used in the ranking methodology.

  • Expense Ratio - This is perhaps the most important factor since it's the one thing investors can control. If you choose a fund that charges 0.1% annually over a fund that charges 1%, you're automatically coming out ahead by 0.9% annually. You can't control what a fund returns, but you can control what you pay for the portfolio. Lower expense ratios equal more money in your pocket.
  • Spreads - This relates to how cheaply you can buy and sell shares. Generally speaking, the larger the fund, the lower the spreads. Bigger funds usually have many buyers and sellers. Therefore, it's easier to find shares to transact and that makes them cheaper to trade. On the other hand, small funds tend to trade fewer shares and investors often need to pay a premium to buy and sell. Considering expense ratios and spreads together usually give you a better idea of the total cost of ownership.
  • Diversification - Generally speaking, the broader a portfolio is, the better chance it has at reducing overall risk. A fund, such as the Energy Select Sector SPDR ETF (XLE), provides a good example. 45% of the fund's total assets go to just two stocks - ExxonMobil and Chevron. By buying XLE, you're putting a lot of faith in just those two companies. An equal-weighted fund, such as the Invesco S&P 500 Equal Weight Energy ETF (RYE), would score higher on diversification than XLE.
  • FactSet ETF Scores - FactSet calculates its own proprietary ETF ranking for efficiency, tradeability and fit. They basically are designed to tell us if an ETF is doing what it sets out to do. I'm not going to copy and paste that work that they're doing, but there is some influence there to make sure my rankings are on the right path.

There are a few other minor factors thrown into the mix, but these are the main factors considered.

One thing that is not considered is historical returns. Most ETFs are passively-managed and are simply trying to track an index, not outperform. ETFs shouldn't be penalized for low returns simply because the index they're tracking is out of favor at the moment.

I'm ranking ETFs based on more basic structural factors. Are they cheap to own? Are they liquid? Do they minimize trading costs? Do they maintain risk-reducing diversification benefits?

Being in the bottom half of the list doesn't automatically make a fund "bad". It simply means that due to a low asset base, a high expense ratio, a concentrated portfolio or some other factor, it poses additional costs or downside risks.

Top Small Cap ETF Rankings For 2022

As expected, the ultra-cheap small-cap ETFs dominate the top 10 of this list, which means you'll see plenty of Vanguard, iShares and SPDR names. This first section of the rankings are mostly plain vanilla beta funds, while the sector, thematic and smart beta options tend to fall a little lower.

Top Small Cap ETFs For 2022

Top Small Cap ETFs For 2022

The #1 spot belongs to the iShares Core S&P Small Cap ETF (IJR), a fund that tracks the S&P 600 Small Cap index. Its 0.06% expense ratio ranks among the cheapest in this space and its $72 billion asset base is the largest, making it incredibly cheap and liquid to trade. Vanguard owns the next two spots - the Vanguard Russell 2000 ETF (VTWO) and the Vanguard Small-Cap ETF (VB). The slightly higher expense ratio and lower asset size compared to its biggest peers makes it slightly surprising to make it all the way up to #2, but it clearly scores well on diversification and efficiency.

The iShares Russell 2000 ETF (IWM) is often considered the small-cap benchmark by investors, but it only comes in at #7 on this list. The big (and perhaps only) reason is its expense ratio. In a universe of ETFs where some funds are separated by razor thin margins, the 0.19% expense ratio of compares unfavorably when the rest of the top 8 come in at 0.10% or less.

Schwab also occupies two spots in the top 10 - the Schwab U.S. Small-Cap ETF (SCHA) and the Schwab International Small-Cap Equity ETF (SCHC), the highest ranking non-U.S. fund on this list. In fact, only two funds in this block just shown come from a fund issuer not named Vanguard, State Street, BlackRock or Schwab - the Avantis U.S. Small Cap Value ETF (AVUV) and the Invesco S&P SmallCap Low Volatility ETF (XSLV). Both come in with expense ratios of 0.25%, which helps them compete with the next tier of low cost ETFs, but their relatively smaller asset bases and higher trading costs prevent them from moving much higher.

The next batch of 30 names includes many of the "next largest" ETF issuers, including WisdomTree, Invesco, First Trust, Nuveen, ProShares and VictoryShares.

Top Small Cap ETFs For 2022

Top Small Cap ETFs For 2022

The Dimensional U.S. Small Cap ETF (DFAS) is worth pointing out because it was one of 4 ETFs created earlier this year by Dimensional that were actually mutual fund-to-ETF conversions. It wasn't the first issuer to go this route - that title belongs to Guinness Atkinson - but it's certainly been the largest. DFAS is the smallest of the four at just over $4 billion in assets, but the quartet combined now manage more than $30 billion total.

I've always been interested in the iShares Morningstar Small-Cap ETF (ISCB), the iShares Morningstar Small-Cap Growth ETF (ISCG) and the iShares Morningstar Small-Cap Value ETF (ISCV). They've got the iShares name. They've got the rock bottom expense ratios. What they don't have are the assets. Combined, they have a respectable $1 billion in assets, but they've largely been lost in the shuffle. These funds overlay a proprietary screen built by Morningstar that focuses on companies with high balance sheet quality and relatively attractive valuations.

The iShares MSCI EAFE Small Cap ETF (SCZ) is the largest international small-cap ETF, but only lands at #37 here. The 0.40% expense ratio simply doesn't score very well in comparison to the plethora of low cost U.S.-focused ETFs available, but it does score well in terms of liquidity and tradeability. If you're looking for foreign small-cap exposure, SCZ would be one to consider.

The iShares Micro-Cap ETF (IWC) is one of just 3 ETFs focused on the smallest of the small stocks. At $1.2 billion, it's got some decent size and likely makes for the best option if you're interested in getting into this space.

Down into the 60s to 80s on this list, you're getting into a lot of sector, region or theme focused funds. These won't necessarily compete with the largest and cheapest funds, since that more targeted exposure comes with a cost, but many are worth consideration in their own rights.

Top Small Cap ETFs For 2022

Top Small Cap ETFs For 2022

JPMorgan is an interesting issuer because, although they got into the ETF game late, they decided to compete on cost through a suite of targeted "BetaBuilders" ETFs. The JPMorgan BetaBuilders U.S. Small Cap Equity ETF (BBSC) is its entry into this group and at just 0.09%, it has a great chance of moving way up this list if it can achieve size and scale.

I've always liked the Pacer Cash Cows series of ETFs. There's a lot of research out there that suggest companies with high free cash flows tend to outperform over time and the Pacer U.S. Small Cap Cash Cows 100 ETF (CALF) provides the exposure to that group.

And the rest of the small cap ETF rankings:

Top Small Cap ETFs For 2022

Top Small Cap ETFs For 2022

Top Small Cap ETFs For 2022

Top Small Cap ETFs For 2022

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