IWO: Low-Yielding Small-Cap Diversified ETF Can Deliver Long-Term Growth

~ by Snehasish Chaudhuri, MBA (Finance)

iShares Russell 2000 Growth ETF (NYSEARCA:IWO) is an exchange traded fund that invests in growth stocks in diversified sectors, but only of small-cap companies. The fund has $9.7 billion in assets under management, with an expense ratio of 0.24 percent, which is quite acceptable. Such stocks typically have overstretched multiples, with unstable margins, saddled with risks of deep drawdowns in case of a sales or profit deceleration. But the side effect of its strategy is unfair valuation and lower quality of the portfolio if compared to large-cap funds, which amplifies risks; this should not go unnoticed for investors who put much emphasis on the valuation and profitability factors.

ETF is Cheaper and Less Time-Consuming Than Individual Small-Cap Stocks or CEFs

Stocks having lower market capitalization (between $300 million and $2 billion), are called small-caps. These stocks are characterized by periods of higher and more frequent volatility than larger peers. In order to reduce market fluctuation risks investors tend to reduce exposure to small-cap stocks, as part of a diversified portfolio of assets. Another strategy is to look for an ETF which can compensate for the exposure to small stocks with a large number of holdings. While investing in such an exchange traded fund is cheaper and less time-consuming than choosing individual stocks or close-ended mutual funds, it is also important to choose a credible fund that delivers value. iShares Russell 2000 Growth ETF perhaps fulfills all the above requirements.

IWO Opts For Fundamentally Strong Small-Cap Stocks Among Diversified Sectors

iShares Russell 2000 Growth ETF was formed on July 24, 2000, by BlackRock, Inc. IWO is managed by BlackRock Fund Advisors. The fund seeks to track the performance of Russell 2000 Growth Index, by using representative sampling techniques. The Index prioritizes stocks that have higher price to book (P/B) ratios, 5-year growth rate of historical sales per share, 2-year consensus sales and earnings growth forecasts. The Index reconstitutes annually. In the case of IWO, management fees remain well under control at 0.24 percent, despite managing 1077 holdings. Fund managers of this fund are more stringent while picking stocks within the index. Investing in U.S. equities becomes a priority, especially due to the dilemma currently faced by the Chinese stocks.

This Diversified Small-Caps ETF Generates Strong Price Growth Over the Long-Run

iShares Russell 2000 Growth ETF invests almost 70 percent of its assets under management in four segments - technology, healthcare, industrial and financial. I strongly believe these four sectors have the largest growth potential in the coming decade. Currently, this ETF has an average P/B ratio of 3.05, average sales growth of 11.54 percent, and an earnings growth of 20.83. Average market capitalization of the small-cap stocks included in IWO's portfolio stands at $2.75 billion. This exchange traded fund is well-diversified with its top 25 holding accounting for less than 12 percent of its entire assets.

Unfortunately, the iShares Russell 2000 Growth ETF fails to generate yield that will satisfy the needs of income seeking investors. Annual average yield over the past 10 years was merely 0.7 percent. However, the good thing is this ETF generates consistent price growth, which enables IWO to post strong annual average total returns. Between 2016 and 2021, annual average total return stood as high as 15 percent. This year too, year-to-date total return stands at 11.46 percent. 2022, as we all know, was a poor year for the broader market.

Multiple Challenges of Investing in a Small-Cap Exchange Traded Fund Like IWO

Small-cap funds generally have liquidity issues that steer many investors away. Overweight companies are either pre-revenue, such as those in the biotechnology industry, or overpriced ones in the application and systems software industries. This means stocks that exhibit questionable growth or value characteristics may qualify for inclusion, creating a challenge for future growth. The index is not mindful of natural sector differences like higher multiples inherent to the IT and lower multiples in the case of, say, materials. iShares Russell 2000 Growth ETF currently has a price to earnings of 18.9, but that figure doesn't include a large number of stocks that didn't generate a profit over the past year. IWO's liquidity problems are problematic, too, and it might be better to avoid this segment altogether and invest in mid-cap ETFs.

Investment Thesis

Small-cap stocks are characterized by periods of higher and more frequent volatility. Exchange traded funds like iShares Russell 2000 Growth ETF not only reduces these risks, but also is cheaper and less time-consuming than choosing individual stocks or CEFs. Its benchmark index prioritizes stocks that have higher P/B ratio, higher growth rate of historical and projected sales and earnings. The fund also makes most of its investments in the US market. The fund is extremely well-diversified, has a considerably high asset under management with an annual turnover of 35 percent. IWO generates marginal yield, but generates strong annual average total returns over the longer period.

In my opinion, high levels of inflation are a transitory factor. Economic outlook also has shown improvement, although not fully recovered. Consumer prices are rising as the economy has started recovering. I expect interest rates not to shoot up any further. IWO's exposure both to healthcare and technology sectors (almost 46.5 percent of holdings) is a positive factor. Finally, iShares Russell 2000 Growth ETF is currently trading almost at par with its net assets. Low yield and volatility risk makes this fund a little unattractive, but the annual average total returns generated over the long-run is good enough for long-term growth-seeking investors. That's why I assign a hold rating for the time being.

About the TPT service

Thanks for reading. At the Total Pharma Tracker, we offer the following:-

Our Android app and website features a set of tools for DIY investors, including a work-in-progress software where you can enter any ticker and get extensive curated research material. 

For investors requiring hands-on support, our in-house experts go through our tools and find the best investible stocks, complete with buy/sell strategies and alerts.

Sign up now for our free trial, request access to our tools, and find out, at no cost to you, what we can do for you.