The Best Russell 2000 ETF for Your Portfolio

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The Russell 2000 is one of the most widely followed benchmarks for small-cap stocks, and thanks to the magic of exchange-traded funds, or ETFs, you can invest in all 2,000 stocks in the index at the same time.

With that in mind, let's take a closer look at these two ETFs and the index they track, in order to see which is the best choice for your portfolio.

What is the Russell 2000?

The Russell 2000 is a stock index that is widely used as a benchmark for the performance of small-cap stocks. The way companies are selected is quite simple -- the Russell 3000 index tracks the 3,000 largest publicly traded U.S. stocks, and the Russell 2000 simply excludes the largest 1,000 of them.

As of June 30, 2016, the average component of the Russell 2000 has a market capitalization of $1.72 billion, while the largest market cap in the index is $4.25 billion.

The most commonly used benchmark used by small-cap mutual funds, investing in the Russell 2000 can be an excellent way to diversify an investment portfolio beyond the large-cap stocks tracked by common indices such as the S&P 500 and the Dow Jones Industrial Average.

What to look for in a Russell 2000 ETF

Before we can compare the iShares Russell 2000 ETF (IWM -0.45%) to the Vanguard Russell 2000 ETF (NYSEMKT: VTWO), let's discuss what we need to look at. When looking for an ETF that tracks a particular index, there are a few things to consider, including:

• Expense ratio -- A fund's expense ratio tells you the percentage of the fund's assets that go toward management fees and other operating expenses each year. For example, if you have $10,000 invested in a certain ETF this year, and its expense ratio is 1%, you'll pay $100 in fees. All other things being equal, a lower expense ratio is better for your long-term investment performance.
• Assets -- As a general rule, index-tracking funds with higher assets can operate more efficiently, but this is only a real factor up to a certain point. Specifically, as long as a Russell 2000 fund has enough assets under management to invest proportionally in all 2000 stocks in the index, the level of assets isn't too much of a factor.
• Performance relative to the index -- Obviously, since the goal of investing in an index-tracking ETF is to match the performance of the underlying index, the fund needs to do a good job of doing that. So, it's important to compare the performance history of each prospective ETF investment to the historical performance of the index it tracks. Some ETFs do a much better job of tracking their index than others.

Comparing the top two Russell 2000 ETFs -- Is one better?

While the iShares fund has significantly more assets under management, both of these funds are sufficiently large enough to track the Russell 2000 efficiently. Both expense ratios are quite low, with a slight advantage for the Vanguard fund.

And, as far as index tracking goes, here's a comparison of the historical annualized returns of these two ETFs and the Russell 2000 index.

Data source: TD Ameritrade (ETF data) and FTSE Russell (Russell 2000 data). Returns are annualized. The Vanguard Russell 2000 ETF's inception date was 9/20/10, therefore 10-year performance data doesn't yet exist.

So, it's fair to say that both funds have done a good job of tracking the index.

Overall, I'd give the edge to the Vanguard Russell 2000 ETF due to its smaller expense ratio and slightly better job of matching the index's actual performance over time. However, a good case could be made for the much larger asset base and longer history of the iShares fund. The bottom line is that either of these can be an excellent way to get exposure to small-cap stocks in your portfolio without relying too much on the performance of any one company.