Small Cap ETFs are Bad: There's a Better Path to Exposure

For decades, the promise of small cap investing has captivated investors with its allure of untapped growth and innovation. The notion that smaller companies—those with market capitalizations between $250 million and $2 billion—offer a pathway to exponential returns has become deeply embedded in the narrative of diversification.

Yet, as with many systems that appear straightforward at first glance, the mechanics of small cap ETFs reveal deeper structural limitations that may render their value less compelling than their advocates claim.

Small cap ETFs, often represented by indices like the Russell 2000, aim to democratize access to the growth potential of emerging firms. However, these vehicles are not simply instruments of inclusion—they are bounded by the very definition of "small cap" itself. 

Growth Pruning

When a company exceeds $2 billion in market value, it must exit the index (for the Russell 2000). 

This structural rule, while seemingly innocuous, creates a paradox: the very success that defines the most promising small cap firms excludes them from further participation in the portfolios of ETF investors. Success, in this context, becomes a barrier rather than a boon.

Another way to think about this is through a lawnmower analogy. Imagine a yard where some blades of grass grow faster than others. The lawn is mowed once a week. But the lawnmower is a special type: instead of cutting all blades of grass to the same height, this mower plucks the tallest blades of grass out of the ground by the roots. 

Over time, the lawn is constantly pruned toward greater representation of slower growing, less promising grass.

Acquisitional Pruning 

This phenomenon is amplified by the gravitational pull of acquisitions. Many small cap companies operate within ecosystems designed not for long-term independence but as stepping stones to absorption by larger enterprises. 

Pharmaceutical startups, for example, often pursue breakthrough innovations with the explicit goal of becoming acquisition targets for global conglomerates. Once acquired, these firms vanish from small cap indices entirely, taking their potential for growth—and the associated returns—out of reach for ETF investors.

Impact Dilution

The dilution effect compounds these issues. To mitigate risk, small cap ETFs typically spread investments across hundreds or even thousands of companies. While diversification protects against catastrophic loss, it also dilutes the impact of high-performing firms. This approach stands in stark contrast to large cap indices, which hold fewer constituents, allowing the success of individual companies to meaningfully influence overall performance. 

Small cap ETFs, by design, cannot fully capture the outsized returns of their most exceptional constituents.

A Rotten Deal

And then there is the question of risk. 

Approximately 44 percent of the Russell 2000 index consists of unprofitable companies—ventures operating at a loss in pursuit of speculative breakthroughs. While some may achieve extraordinary success, the majority will fail, rendering the aggregate performance of the index uneven at best. 

These companies are often willing to operate at a loss in pursuit of a breakthrough—whether it be a novel drug or a significant energy discovery. While individual investors may occasionally benefit from these high-risk, high-reward plays, small cap ETF investors rarely do: As valuations exceed the small cap threshold, fund managers are required to sell, leaving ETF holders with the risks but not the full rewards.

This raises a broader question: is the promise of small cap growth merely a narrative of high risk and marginal reward, particularly for ETF investors who cannot directly benefit from the few breakout successes that transcend the index's boundaries?

At the heart of this reflection lies a deeper principle: the dynamics of small cap ETFs mirror the limits of linear systems. These funds operate within rigid definitions, unable to accommodate the nonlinear trajectories of true innovation or sustained growth. In much the same way that artificial intelligence systems are bound by the constraints of linear reasoning, small cap ETFs are bound by their structural design—unable to transcend the rules that govern their composition. 

The result is an instrument that may simulate exposure to growth but ultimately fails to harness the full potential of the opportunities it seeks to capture.

Large cap indices, with their ability to retain and amplify the gains of successful companies, may offer a more stable and rewarding alternative. Meanwhile, actively managed small cap funds or direct stock selection could provide opportunities to engage with the dynamic potential of smaller firms without succumbing to the limitations of ETF structures.

A Better Path

It turns out that you can have the best of both worlds. 

Below is a list of small-cap growth ETFs. With a minimum of effort, one can compile a non-redundant composite list of the top ten holdings for all of these ETFs.

Consider that list to be a starting point as a research universe. You can own all stocks on this list or narrow it down to your favorite ten. 

Chances are, either way, you will stand to outperform the Russell 2000 over the long term if you actively manage this exposure, maintaining positions where growth stories are working, getting rid of positions that falter.

Why Make Room for Flawed Instruments?

For long-term investors, pairing this strategy with indexed exposure to major large-cap indices stands to offer a path to market-cap diversification without taking the many flaws of small-cap ETFs on board in the process.

As we navigate the uncertainties of the investment landscape, the case against small cap ETFs is not an argument against small cap investing itself. Rather, it is a call to reimagine how we approach growth, innovation, and risk in an interconnected world. 

Success, after all, is not merely a matter of following the rules—it is about knowing when to transcend them. 

"What about your IWM recommendation last November?"

Let's confront this preemptively because I know the questions will come.

Yes, I recommended IWM in early November 2023, along with LABU, DPST, and ARKK. And I stand by that recommendation even in light of everything outlined above.

Why? Because those were intermediate-term tactical trading recommendations suited for a multi-week or multi-month time horizon, rather than a long-term portfolio strategy.

As you can see in the chart shown above, those positions have advanced anywhere from 40% to 200% in the past year. Those recommendations were predicated upon the assumption of a shift at the Federal Reserve from a hawkish hiking cycle to a dovish easing cycle in 2024.

All four of these ETFs tend to underperform during periods of rising rates and outperform during periods of falling rates because they all represent what Wall Street folks call "duration risk". In other words, they all focus on holdings that may be big long-term winners but have little to show in terms of earnings at this stage. 

IWM clearly falls into this category of investment vehicle (other aspects notwithstanding). Hence, it was included in my recommended tactical list as the Fed pivoted in early November 2023.