If you are like most investors today, you likely own index funds in your portfolio, particularly in company retirement plans. Index funds are a very low-cost way of getting exposure to an asset class. Not all asset classes are created equal, however. For example, an index fund matching the SP500 is very effective as there is some selectivity in the underlying index, and results are driven by the largest companies in the U.S. On the other hand, when investing in small or mid-cap asset classes, following a broad index may not be optimal.
The most widely followed small-cap index is the Russell 2000, which contains about 2000 stocks. A popular and low-cost ETF following the Russell 2000 is IWM. The Russell 2000 and IWM stocks are selected from the Russell 3000. The Russell 3000 are 3000 stocks, representing most of the U.S. stock market capitalization. The Russell 2000 comprises the 2000 smallest companies within the Russell 3000. Investing in small companies as part of your overall portfolio is good from a diversification standpoint, as they can grow over time.
The danger, however, is that the Russell 2000 contains quite a few so-called zombie companies – companies that may not be able to sustain themselves. Using data from Y-Charts.com at the end of July 2023, roughly 40% of the companies in the Russell 2000 have negative earnings for the trailing twelve months. 42% have cumulative earnings over the past five years. Suppose you buy an index fund designed to invest in the Russell 2000 or another similar small-cap index. In that case, only 60% of your investment is in profitable companies. Of course, some of the negative earners may succeed long term, but if you were buying a small business, wouldn’t you want a profitable one? One that can generate sufficient cash flow to invest in growth and eventually distribute cash to investors.
Many mutual funds and ETFs in the small-cap space introduce screens on profitability, earnings growth, or cash flow. Some are actively managed, while others are more passive. If you are including small-cap allocations in your portfolio, these more selective funds are worthy of consideration rather than investing in a fund strictly mimicking the entire Russell 2000.