Small Change: New ETFs Muddy Waters of Small-Cap Index Funds - TheStreet

Small Change: New ETFs Muddy Waters of Small-Cap Index Funds

As exchange-traded funds alter the landscape, investors should keep it simple in choosing small-cap index funds.
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Buying an index fund is supposed to be simple.

But with the recent explosion of exchange-traded funds, the once-staid world of index funds has gotten complicated. And when you get down to index funds for small-cap stocks, it can get downright murky.

A recent

column discussed the new technology index funds that are hitting the market and their obvious and not-so-obvious differences. Today's column will examine small-cap index funds, and advise that, even in this new landscape, investors serve themselves well by keeping it simple.

Up until a few weeks ago, you couldn't find an exchange-traded small-cap index fund. They didn't exist. Then

Barclays Global Investors

came along and launched two: the

iShares Russell 2000

(IWM) - Get Report

and the

iShares S&P SmallCap 600

(IJR) - Get Report

funds. (Unlike traditional mutual funds, exchange-traded funds trade like stocks. You don't actually invest money in a portfolio but instead buy shares in the secondary market from other investors and market-makers.)

Within the next few months, you will see six more specific small-cap ETFs. Barclays will come out with

iShares Russell 2000 Growth

(IWO:Amex) and

Value

(IWN:Amex) funds and

S&P SmallCap 600/BARRA Growth

(IJT:Amex) and

BARRA Value

(IJS:Amex) funds.

Also, State Street will come out with two small-cap funds that cater to specific investing styles: the

SSgA Dow Jones U.S. Small Cap Growth

and the

Dow Jones U.S. Small Cap Value

funds.

These new offerings leave investors with a dizzying array of choices. With the offerings, you will not only have to choose between index providers. You'll also have to choose between styles. Trying to predict which style will outperform and when is practically impossible. Most investors should just stick with a broad small-cap fund and should not bother with trying to dissect the style-specific indices.

Like I said at the beginning: Keep it simple.

That means deciding between the

Russell 2000

and the

S&P SmallCap 600

, two indices that are strikingly similar.

The two market-cap weighted indices behave very similarly to one another. (A market-cap weighted index allows the larger companies to carry a greater influence on performance.)

They are closely correlated when comparing their performance over the last 10 years. With a 1 meaning two securities move exactly together and a negative 1 meaning their move inversely, the Russell 2000 and the S&P SmallCap 600 have a correlation of 0.98, according to data provided by

Charles Schwab's Center for Investment Research

.

"There is some small difference, but for all intents and purposes, they are the exact same," says Bryan Olson, director of Schwab's research center.

The market capitalizations of listed companies are also close. The median market capitalization of the Russell 2000 is about $440 million. The S&P SmallCap index's median market cap is around $458 million.

Their sector allocations can also line up. At the end of March, the Russell has 29.4% allocated to software, computers, semiconductors and electronics. The S&P index had 27.3% dedicated to the same four groups. These two iShares funds also cost the same at 0.2% a year.

However, if you want a broader, more true small-cap index, you should go with the Russell.

The Russell, for one, is a broader benchmark, with 2000 stocks compared to the 600 names in the S&P SmallCap index.

With the Russell 2000, you will end up with a more pure small-cap index.

Frank Russell's

approach to selecting stocks for this index is quantitative, while

Standard & Poor's

is more qualitative. Russell looks only at market cap to determine which companies go into the index. (The company rebalances the index once a year at the end of June.)

S&P takes a more qualitative approach and runs its indices "by committee rather than by rule book," says David Blitzer, chairman of S&P's index committee. S&P will promote and demote companies as necessary, say when there's a merger or acquisition that makes a change essential.

Because of these irregular changes, you will find several stocks that should be in the S&P SmallCap index that are not. If you took 1,500 stocks represented in the

S&P 500

, the

S&P MidCap 400

and the

S&P SmallCap 600

and ranked them according to market cap, you'll find 20 stocks in the large-cap 500 that should be in the SmallCap index, says Diane Garnick, derivatives strategist at

Merrill Lynch

.

"They don't remove companies when they should," says Garnick.

Stocks such as

Polaroid

(PRD)

and

Bethlehem Steel

(BS)

are in the S&P 500 but should be in the S&P SmallCap based on their market-cap ranking, says Garnick. There's one stock in the SmallCap index -- testing-software manufacturer

Mercury Interactive

(MERQ)

-- that should be in the 500 based on its market cap.

The Russell 2000 is your choice.

If you start looking at the style-specific indices, the S&P indices do have one noticeable advantage. The division between growth and value is clear and easy to understand. The stocks are ranked by price-to-book value with the low value stocks going into the value index and the high value stocks going into the growth index.

Russell uses a second variable -- long-term forecasted earnings growth -- to differentiate between growth and value indices. Some companies are deemed to have both growth and value elements, so they show up in both indices.

The new Dow Jones indices use six factors to determine the style characteristics of the stocks in the universe, including projected and trailing price-to-earnings valuations.

The Russell and S&P small-cap style index funds will all have annual expenses of 0.25% when they launch. The State Street Dow Jones funds haven't been priced but you can expect their expenses to be competitive.

For many investors, the final decision will inevitably come down to cost.

Send your questions and comments to

deardagen@thestreet.com, and please include your full name.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.