RWJ: Leading Small Cap ETF with Deceptive Track Record

investment paper

Invesco S&P Small Cap 600 Revenue ETF (NY SEARCA: RWJ) was the best performing small-cap ETF on the market. Still, RWJ is struggling to raise new funds due to his high 0.39% cost. Ratios and past volatility above average. This article explores these issues in detail and highlights the positives, such as a reasonable allocation to energy stocks and his extremely low future earnings valuation of 12.5x. Given the many uncertainties today, I am not yet ready to recommend this high beta ETF. However, if the stock market continues to fall, RWJ will be ready to profit.

Overview of ETFs

Strategy, sector exposure and performance

RWJ tracks the S&P SmallCap 600 Earnings Weighted Index, selecting stocks from the S&P SmallCap 600 Index and reweighting them based on their earnings over the last four quarters.Indices rebalance quarterly and S&P The Dow Jones Indices define small caps as having a market capitalization between $850 million and $3.6 billion. There are currently 186 stocks outside these bands, representing about 20% of the portfolio. Such a realignment is consistent with historical portfolio turnover rates of 15-20% since 2017.

Morningstar places RWJ in the small value category, but the exposure in that sector raises some questions. RWJ has 23.86% consumer discretion, approximately double the exposure of SLY, SLYV and SLYG. We are also underweight financial stocks, which are often favored in value strategies. However, his 9.05% exposure to tech stocks is low, so it might be best to call RWJ a small-cap blended ETF.

After all, RWJ has been the best performing small cap ETF over the last 3, 5 and 10 years, so category doesn’t matter. In addition, it is second only to the previous year against 77 other companies in the same industry. We couldn’t narrow it all down in the table below, but here are the 30 biggest by AUM. RWJ barely qualified, ranking 29th in size.

RWJ’s 10-year return of 244.97% beats the next best performer, SLYG with 200.41%. Its 84.07% 5-year return outperforms the Pacer US Small Cap Cash Cows 100 ETF (CALF) by 19.06%. Finally, its 3-year 92.59% also beats his CALF by 28.66%. Last year alone, RWJ’s 6.77% decline outpaced his three S&P 600 ETFs, so the strategy looks like it has merit.

Looking back at RWJ’s launch in February 2008, it is up 11.26% annually, outperforming SLYG by 0.90%. However, the following chart shows a higher beta, putting downward pressure on risk-adjusted returns (Sharpe and Sortino ratios). RWJ still looks good, but remember this was mostly a bull market.

Choosing a good return period is easy, and graphs like the one above can mislead investors. Instead, consider the 3-year rolling return charts of the following four ETFs. RWJ shareholders will see that he underperformed from 2014 to 2020. You can get that confirmation at: this linkwhich indicates that RWJ lags SLYV, SLY, and SLYG by 0.22%, 2.19%, and 3.89% per year, respectively.

Finally, if I were writing this article in January 2020, I present this chart that suggests RWJ is nothing special.

In short, be careful how you interpret RWJ’s long-term historical returns. Portfolios change, and so do the factors that the market favors. As such, most of my analysis of his ETFs focuses on current portfolio fundamentals. Let’s do that next time.

ETF analysis

Composition by industry

RWJ’s top 25 industries account for 61% of the ETF, with Oil & Gas Refining & Marketing leading the way at 7.20%. World Fuel Service (INT) and the PBF energy (PBF) is a major holding and has seen significant earnings growth, so we expect it to gain weight when the index rebalances. These are very good anchor stocks and I think his 9.62% allocation to RWJ’s energy sector is close to what I think is appropriate.

Food distributors led by United Natural Foods (UNFIMore), followed by 5.37%, and the industry has held up pretty well over the past year. All holdings (UNFI, ANDE, SPTN, CHEF) delivered positive sales and earnings surprises last quarter, earning Seeking Alpha EPS revision grades ranging from B+ to A+.

RWJ’s five auto retail stocks have value written all over them. Sonic Automotive (SAH) and Group 1 Automotive (GPI) are his $13.5 billion and $14.9 billion annual sales, but both remain firmly in small-cap territory.sonic disappointed investor However, it continues to ramp up what it believes to be an aggressive share buyback program.

These three industries are RWJ’s most overvalued industries relative to SLY. Instead, RWJ is underweight regional banks (7.62%), biotech (1.89%) and retail REITs (1.74%).

Fundamentals: Good valuations, high volatility

The following table presents a selection of basic metrics for the same top 25 industries. This analysis shows that RWJ has similar levels of sales and profit growth to SLY, but trades at a much lower valuation. RWJ is 4.94 points cheaper on futures earnings, 1.93 points cheaper on trailing sales, and 2.79 points cheaper on trailing cash flows.

However, there are risks in purchasing such discounted funds. Consider that RWJ is the 10th cheapest small-cap ETF and the second most volatile. The cheapest ETFs on forward P/E are CALF, XSVM, and AVUV, and they also have high 5-year betas. Perhaps the reason for their big returns is that they are riskier and we have been in an uptrend market for most of the last decade.

Another significant risk is that reweighting small-cap stocks by earnings reduces portfolio quality, as suggested by the decline in profitability scores (C+ vs. B-). RWJ ranks 53/78 on this metric, which could be a problem if market sentiment is negative. In general, RWJs have significantly higher drawdowns than SLYs, but often have much shorter recovery times. Given the similar year-to-date declines in both ETFs, it’s probably wise to wait for signs that a recovery is underway.

Performance of mid- and large-cap ETFs

Invesco also offers mid- and large-cap income-weighted ETFs. The following chart highlights the rolling returns compared to the benchmark.

Invesco S&P Mid Cap 400 Revenue ETF (RWK) SPDR S&P MidCap 400 ETF (MDY) over all roll periods. However, average returns appear to get progressively worse as the holding period increases. The 1-year holder outperforms her MDY by 1.43% per year (14.58% vs. 13.55%), but that advantage is lost in his 3-, 5-, 7-, and 10-year roll periods.

Large ETFs are RWL When spyfollows a similar pattern to Mid-Cap, but with no average advantage over any rolling period. The one-year average returns are close (13.65% vs. 13.85%), but the RWL is down 0.72% over the decade.

Finally, here are the same metrics for RWJ and SLY: One standout figure is the 173.48% profit RWJ achieved from April 2020 to March 2021, outperforming SLY by 77.01%. I would be wary of relying on repeating such gains, even if they are inevitable once every five or ten years. I don’t think a 15-17% drop would qualify.

Investment recommendation

RWJ has an impressive long-term track record, which has been fueled by post-pandemic returns that I doubt will repeat anytime soon. The main negative factors are his 0.39% expense ratio, high volatility and low profitability score. Still, the low future earnings valuation of 12.5x and still-strong sales and earnings growth are notable positives. I think RWJ is a good fund, but I feel more comfortable recommending it after a big stock market drop. If so, we look forward to providing updates at that time.