October 2003

I just put some money into IWN (Russell 2000 Value Index), which is an ETF (Exchange Traded Fund). After a lot of research, I concluded that this was a very good choice for a long-term investment in a taxable account. Here are some of my reasons for this choice:

1. Exchange traded funds are much more tax efficient than mutual funds. It can’t be explained briefly, but here are some good articles on it. If you’re investing in an IRA, then an index fund is fine, but in a taxable account an ETF is more like a stock.



2. The Russell 3000 Index represents the 3000 biggest US companies (98% of the market). The Russell 1000 consists of the 1000 companies with the largest market capitalization, and the Russell 2000 is the rest (about 10% of the market) – the small-cap companies. Small-cap companies have been doing well for the last few years, although there’s no guarantee that this will continue indefinitely. The contrarian book I’m reading, (Contrarian Investment Strategies: The Next Generation by Dreman) shows that small-cap stocks with low P/E ratios significantly out-perform large-caps with low P/E ratios in the long-run.



3. The Russell 2000 Value Index is the half of the Russell 2000 with “lower price-to-book ratios and lower forecasted growth values”. These tend to be the stocks with low P/E ratios, although not necessarily. It is rebalanced every 6 months (I believe) to get rid of those stocks that have been performing too well. Value funds tend to go up less than growth funds in bull markets; and go down less than growth funds in bear markets. In general, value funds contain the underappreciated (Low P/E) stocks that tend to go up. Here’s an interesting paper supporting the small value thesis.

The following chart compares the performance of the Russell 2000 Value Index (IWN), the Russell 2000 Index (IWM), and the Russell 2000 Growth Index (IWO), with the NASDAQ index (^IXIC). You can see how IWN has held its value nicely over the last two years. If you want to track the indices instead of the ETFs, here's the mapping: IWN = ^RUJ, IWM = ^RUT, IWO = ^RUO.

For comparison, here’s how the Russell 1000 (big company) growth and value funds did over the same period. IWD is the value index, IWB is the index, IWF is the growth index. As with the small cap stocks, the value fund outperformed the growth fund. NASDAQ (^IXIC) is shown again, as a benchmark.

To me this shows that value stocks are preferable to growth stocks, and that small stocks are preferable to big stocks; but trends like these tend to change over time as people start to notice them.

Here’s another comparison – I sorted the ETFs by volume, and here’s how the biggest ones have done over the last two years: QQQ = NASDAQ 100, SPY = S&P500, DIA = DJ Industrials, IWM = Russell 2000, IWN = Russell 2000 Value.

Just a warning, if you do these same comparisons over shorter periods of time, you’ll see the growth funds climbing above the value funds. But if you plan to invest the money for two years or more, then I believe the value funds are your best bet.

Here’s a slightly longer-term chart, which starts at the inception of the IWN ETF 7/24/2000. Pretty impressive, isn’t it!!

May 2005

It has been a while since I posted this article, and IWN has continued to outperform the other broad indices. Here's a current version of the previous chart (again starting at 7/24/2000):

I've been reading a very interesting book, called Bull's Eye Investing, by John Mauldin. In it he makes a very strong case that we are in the early stages of a secular bear market, meaning a bear market that could last for a number of years (or even a decade). If you believe this, a buy and hold investment strategy is probably not the way to go. However, he does have a chapter talking about how small-cap value stocks are the best sector for the long-haul. So if you must buy and hold, IWN is a good place to start. He also has a brand new article called The Problem with Indexes, which may help explain why IWN outperforms traditional index funds.