How to Choose the Right Small-Cap Fund or ETF

by Nancy Zambell, Contributing Editor, Financially Fit

The last two issues of Financially Fit have been devoted to small-cap investing, a segment of the market that can substantially boost your investment returns.

Our introduction featured a definition of the market, along with performance statistics, as well as potential dangers that particularly trap unwary or novice investors.

Last week’s issue offered a comprehensive guide to help you analyze the investment merits of small-cap companies – on a quantitative, as well as qualitative basis.

And although the purpose of Financially Fit is educational in scope, and generally not a vehicle offering specific investment recommendations, this week’s issue – focusing on analyzing small-cap mutual funds and exchange-traded funds (ETFs) – should provide you a few investment ideas to help you get your feet wet in the small-cap market.

Let’s start with Mutual Funds. Our August 15, 2006, issue of Financially Fit extensively covered the evaluation and selection of mutual funds. The three most important determinants also apply to small-cap funds:

Performance: The easiest way to gauge the success of a fund is to look at its returns – annually, as well as over time. Cumulative performance will tell you a lot about a fund’s consistency, and how it has fared in relation to its peers, over time. However, be aware that one very good (or bad) year can greatly exaggerate (or underestimate) average cumulative return. Therefore, it is imperative that you compare fund returns – one year at a time – to see how they are currently performing. My favorite web site for mutual fund analysis is http://www.morningstar.com/According to Morningstar, here are the recent average annual returns for the three primary types of small-cap mutual funds:

As you can see, small-cap value funds have beaten growth and blend funds for the past five years, but so far, are underperforming in 2007.

Expenses: These costs are not just confined to the expense ratio, the most commonly published cost parameter. You must also consider the fund’s load, 12b-1 fees, as well as taxes generated for short-term holdings. Fortunately, most of this information can be retrieved from Morningstar’s web site. Here are Morningstar’s recent averages for small-cap fund expense ratios:

Small-cap value: 1.54%

Small-cap blend: 1.47%

Small-cap growth: 1.65%

Expenses can take a big bite out of your returns and can range from barely nothing to more than 3%, so it behooves you to compare net returns – after expenses – to find the best performing funds. Here are a couple of other sites that will help you compare expenses from fund to fund:

http://www.sec.gov/investor/tools/mfcc/mfcc-int.htm

http://www.sec.gov/edgar/searchedgar/prospectus.htm

Turnover: The constant buying and selling in a fund can rapidly rack up costs – from commissions as well as short-term taxable gains. Of course, if that turnover is producing fantastic returns, it may not be a worry.

ETFs typically are created to track a particular index and have certain advantages over mutual funds, including lower expenses, greater liquidity, less capital gain distributions and no minimum investment.

Our August 1, 2007, Financially Fit issue covered exchange-traded funds. And you can find additional information on the following web sites to help you with your ETF research:

http://screen.morningstar.com/etf/Lists/ETFStyleVolDescAllAll.html

http://funds.reuters.com/lipper/retail/reuters/lipperperformingfunds.asp?type=etf

http://finance.yahoo.com/etf

The two factors crucial to analyzing ETFs are performance and expenses. And since ETFs generally track indexes, neither number should vary greatly from the index.

Performance. Just as with mutual funds, Morningstar’s universe of small-cap growth ETFs are the year-to-date winners with average returns of 1.39%, followed by small-cap value at 0.22% and small-cap blend at -0.26%. Since ETFs are still fairly new, long-term track records are not yet available for them. However, Yahoo reports that for one year, small-cap value is tops (20.9%), followed by small-cap blend (17.1%), and small-cap growth (12.7%).

Expenses. Although ETF expense ratios are generally less than those of mutual funds, an astute investor will compare them with the ETF’s performance to ensure they are receiving stellar returns for the added cost.

Morningstar lists seven small-cap value ETFs with expense ratios ranging from .12% to .66%; and 13 small-cap blend and seven small-cap growth ETFs with expense ratios from .10% to .75% and .12% to .65%, respectively.

To assist you in your research for the small-cap funds and ETFs that will best suit you, I’ve listed the recent top performers in the following table:

Source: Morningstar

As shown, sometimes stellar growth is accompanied by hefty expense ratios, and sometimes, not. Funds and ETFs can help you add needed diversification to your portfolio. But – as with all investments – make sure they fit your personal strategy and risk profile.

Until next week…

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


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