If you're interested in the stock market and want to invest in it, a good way to do so is via an exchange-traded fund, or ETF, that's based on a broad index. For those interested in small-cap stocks, the iShares Russell 2000 ETF (NYSEMKT:IWM) is an easy and inexpensive way to hold a stake in roughly 2,000 of them. Its average holding has a market capitalization of about $1.5 billion.
It may not be the perfect investment for you, though. Here are a few reasons you might want to pass on this ETF.
Not the best structure
For starters, the iShares Russell 2000 ETF is weighted by market capitalization, meaning that it holds its 2,000 components in proportion to their market value. Its top holding, recently Isis Pharmaceuticals, has a market cap near $6.3 billion and recently made up about 0.36% of the fund's assets. Jack in the Box has a market cap near $3 billion and thus has a weighting about half as big as Isis'. Therefore the higher-weighted holdings wield much more influence over the index. A minor holding might quadruple in value, but that will barely register.
For those who don't like this structure, there are some alternatives to the iShares Russell 2000 ETF, such as the Guggenheim Russell 2000 Equal Weight ETF or the RevenueShares Small Cap ETF. The equal-weighted ETF, which gives each holding an equal portion of the portfolio, has underperformed in its category, but the RevenueShares ETF, which weights its holdings by revenue, has been an outperformer in its category. Its annual fee of 0.54% is considerably higher than the iShares Russell 2000 ETF's 0.2%, but its outperformance more than makes up for that.
Too many stocks
Another knock against the ETF is that, while it does offer diversification across many industries, that range is huge. With about 2,000 holdings, it's hard for any explosively growing company to have much of an effect -- and the potential for rapid growth is one of the appeals of small-cap stocks in the first place. Thus this investment isn't likely to ever double in a year, as an individual stock can do.
The diversification among industries might also not be to your liking. Defensive industries like healthcare, utilities, and consumer staples only make up about 16% of the ETF's holdings, while cyclical industries such as financial services, real estate, basic materials, and consumer discretionary make up about 43%. Industries sensitive to economic cycles, such as industrials and technology, make up 41%. Thus when the economy moves through its usual phases, the ETF's fortunes will follow suit.
Finally, though small-cap stocks often outperform large-cap stocks, that's never guaranteed, and this ETF has slightly outpaced the S&P 500 during the past five years, though it has lagged a bit during the past three and 10.
Taking the lumps
Another drawback to investing in a big batch of companies is that you'll be getting the good and the bad, and you'll have to settle for the weighted average return of all 2,000 stocks.
Further, when the most successful companies in the ETF surge, shareholders don't get to enjoy their performance for long, as these rising companies outgrow the small-cap class and are therefore removed from the Russell 2000 Index and any ETFs that track it. The small-cap arena is where many stars first reside, but the best of them move out. This isn't necessarily a reason to sell or avoid the ETF, but it's something to be aware of.
Despite the drawbacks of this ETF, it's still worth some consideration, as it's smart to include small companies in a balanced portfolio of stocks. This one even offers a modest dividend yield -- something you won't find from many individual small-cap stocks.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns shares of Isis Pharmaceuticals. The Motley Fool recommends Isis Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.