iShares Russell 2000 Value ETF (NYSEARCA:IWN) owns a group of small-cap value stocks. These stocks trade at lower valuations but also have lower forecasted growth potential than the broader small-cap space. IWN's portfolio of small-cap stocks generally are not as established as other mid-cap and large-cap stocks. Hence, IWN may exhibit higher volatility especially during economic turmoil. Given successful small-cap stocks that do not stay as small-cap for long, and that they will soon graduate from small-cap space and join mid-cap or large-cap space, IWN will be unable to reap the full benefit of owning these successful stocks. Therefore, IWN will likely continue to underperform its mid-cap and large-cap peer funds. Hence, we see little reason of owning IWN and we recommend investors to seek other funds instead.

Fund Analysis

Attractive valuation but there are reasons why

IWN has a portfolio of about 1,400 small-cap value stocks selected from the Russell 2000 index, an index that focuses on small-cap stocks. To be included in IWN's portfolio, stocks must exhibit value characteristics. According to the prospectus document, these stocks must have lower P/B ratios, lower historical sales per share growth, lower forecasted growth relative to the Russell 2000 index.

Based on the selection criteria, we established our understanding that these stocks may trade at a low valuation than other small-cap stocks. If these low valuation stocks in IWN's portfolio have good growth potential, it makes sense to own IWN. However, the selection criteria also tells us that these stocks have lower growth forecast relative to the Russell 2000 index. Hence, it is not difficult to discern that stocks in IWN's portfolio will likely deliver lower growth and hence lower return than the Russell 2000 index in the long run. A closer look at IWN's sector allocation also reveals that the fund has limited exposure to fast-growing sectors such as information technology as the sector only accounts for about 6.1% of IWN's portfolio. For reader's information, the Russell 2000 index has a 13.3% exposure to technology sector.

IWN's lower growth potential means that it will inevitably underperform against its peers in the long run. This is exactly the case in the past 10 years. As can be seen from the chart below, IWN's total return of 80.7% in the past 10 years was lower than iShares Russell 2000 ETF (IWM) and iShares Russell 2000 Growth ETF (IWO). Based on our analysis, this underperformance to IWM and IWO will likely continue in the foreseeable future.

Small-cap stocks are not as established and strong as mid-cap and large-cap stocks

What about large-cap stocks? Will IWN outperform its mid-cap and large-cap peers? To answer this question, we need to discuss about the differences between small-cap and mid/large-cap stocks. Small cap stocks usually do not have strong balance sheets as mid-cap and large-cap stocks. They also may not have yet fully established their business models. Hence, they are usually much weaker than mid-cap and large-cap stocks especially during economic recessions. They are just like small boats going through a storm, the ride can be quite shaky for investors to take. Hence, it is not surprising to see these stocks decline much harder than mid-cap and large-cap stocks in economic/market turmoil. In fact, IWN's beta ratio (an indicator of an equity's volatility) of 1.03 is much higher than the 0.87 beta ratio of iShares S&P 500 Value ETF (IVE), an ETF that owns a portfolio large-cap value stocks from the S&P 500 index.

IWN's long-term growth is inferior than its mid-cap and large-cap value peers

Investors need to understand one important rule of law: successful small-cap stocks will not stay in small-cap category for too long. These successful stocks will soon become mid-cap and large-cap stocks, not to mention that growth stocks will likely not be selected in IWN's portfolio in the first place. Even if these successful stocks were included in IWN's portfolio, they will soon graduate and enter mid-cap category. Therefore, IWN will not be able to reap the full benefit of owning these successful small-cap stocks. We believe this will cause IWN to underperform its mid-cap and large-cap peer funds in the long run. Below is a chart that shows how IWN performed in the past relative to its mid-cap and large-cap value peers. As can be seen, IWN's total return of 80.7% underperformed the 104.8% total return of the iShares Russell Mid-Cap Value ETF (IWS) and 152.6% total return of IVE. This underperformance will continue to be the trend in the future as well.

Low concentration risk

IWN has little concentration risk. In fact, its top 10 holdings only accounts for less than 5% of its total portfolio. Its top holding, Commercial Metals (CMC), only accounts for about 0.52% of the total portfolio. Given that the fund has about 1,400 stocks, we are not concerned about its concentration risk.

The trend of passive investing means large-cap stocks will get more attention

One may think that the trend of passive investing (e.g. investors opting for ETFs rather than actively managed funds) will benefit all ETFs. This perception is not entirely accurate though. ETFs that will benefit the most from this trend are large-cap ETFs rather than mid-cap and small-cap ETFs as investors typically buy large-cap funds that track major indices such as Dow Jones, S&P 500 index, and the Nasdaq 100 index. These indices basically only include large-cap stocks. As more money pour into buying large-cap ETFs, it becomes even harder for small-cap funds such as IWN to outperform large-cap funds.

Investor Takeaway

In conclusion, stocks in IWN's portfolio do not have strong growth characteristics and hence IWN will likely underperform the broader small-cap space in the long run. IWN's portfolio of small-cap stocks are not as established as other mid-cap and large-cap stocks as well. Hence, they will likely underperform them in economic turmoil. Since we are unable to find a good reason to own IWN, we recommend investors to look for other funds instead.