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A Host of Small Cap Options to Choose from for ETF Investors
By Nancy Zambell, Contributing Editor
At the beginning of 2007, Financially Fit brought you a series of articles on small-cap investing. We covered the advantages (on Jan. 16, 2007), the analysis (Jan. 23, 2007) and how to choose the best small-cap funds and exchange-traded funds (ETFs) (Jan. 30, 2007).
ETFs have seen unparalleled growth in the last few years, but especially in 2007, and that includes the small-cap category.
Depending on the index, the definition of small-cap stocks varies, but most analysts consider small caps to be companies whose market capitalizations range from $300 million and $2 billion. Until 2007, small caps were on a five-year tear, outperforming many of their larger brethren. But last year, according to Lipper, small-cap stocks returned an average of only 1.4%.
The reason for this rout was primarily the subprime mess, when small companies suddenly had a difficult time finding credit and investors flocked to more stable, large-cap blue-chip stocks.
However, there are a couple of reasons why investors should not turn up their noses at this niche:
Small caps provide extra diversification to your portfolio, while offering the potential to push returns higher in good markets.
The growing correlation between international and domestic U.S. large-cap companies is providing a boost as investors begin to dip their toes into international small-cap stocks and emerging markets.
This has not gone unnoticed by the ETF market, which continues to bring out a variety of small-cap exchange traded funds - some good, some not-so-good. Today, there's an ETF for everyone, whether based on sponsor, style, fees, performance, or the index it tracks.
New-Fangled Indexes
One important aspect that investors need to be aware of that can potentially affect returns is the calculation of the indexes that your ETFs track.
For example, many ETFs follow the traditional market-cap-weighting of the S&P indexes they track, which simply means that the larger companies (by market cap) have a bigger influence on the index.
Others, including the Wisdom Tree family of ETFs, as well as the new RevenueShares ETFs (Small Cap Fund RWJ), use fundamentally-weighted indexes, based on fundamental parameters such as revenue, dividend rates, earnings, or book value. Mark Hulbert, publisher of The Hulbert Financial Digest says that "The major attraction of fundamental indexing is that, relative to cap-weighted indexes, it will underweight stocks that are overvalued and overweight stocks that are undervalued." One note of caution here, though: carefully check the expense ratios, as some of these ETFs tend to be on the high side.
PowerShares bases its ETFs on the Dynamic Intellidex index, essentially a stock-picking strategy. According to PowerShares, the calculation takes into account 10 factors that segregate companies into their appropriate investment style and size universe, then evaluates each using fundamental, valuation, timeliness and risk criteria.
Morningstar selects the stocks in its ETFs, using a proprietary index methodology based on above-average "growth" characteristics.
You will find advocates for all of these methodologies, but the important point is that you realize which calculation is used, so that you are indeed comparing apples to apples when selecting your ETFs.
Watch Out for Those Expenses
Don't be blinded by returns, without investigating the expenses and fees charged by the ETF. For example, the range of expense ratios varies tremendously. Here are the latest results from Morningstar:
1) Eight small-cap value ETFs with expense ratios of 0.12% to 0.95%
2) 19 small-cap blend ETFs with expense ratios of 0.10% to 0.84%
3) Nine small-cap blend ETFs with expense ratios of 0.12% to 0.95%
As you can see, the expenses vary considerably, so make sure that you also compare the fees, as well as the returns before you select your ETFs.
Morningstar offers a great ETF screener, where you can find this as well as other parameters:
http://screen.morningstar.com/ETFScreener/Selector.html
Long-Term Track Records are Hard to Find
Since so many ETFs just came to market last year, you are not always going to be able to find 3- and 5-year track records. Therefore, you will need to investigate the returns of the underlying stocks included in the ETFs. Reuters has a good website for this criterion:
http://www.reuters.com/finance/stocks?ticker=lscp, then click on ratios. It's imperative that you make sure that the companies included in the ETF have a track record, and one that is fairly consistent, in terms of revenues, earnings and performance.
Growth, Value or a Blend?
Now that you know what to look out for, let's talk about the types of small-cap ETFs that are available.
The three main categories that investors may choose from include growth, value and a blend of the previous two. For 2007, the returns for small-cap value and blend were not too good. According to Morningstar, returns on small-cap value ETFs ranged from
-13.12% (SPDR DJ Wilshire Small Cap Value DSV) to -54.36% (iShares Dow Jones US Home Construction ITB) while small-cap blend ETFs returned -10.62% (iShares S&P Small Cap 600 Index IJR) to -33.23% (Ultra Russell2000 ProShares UWM).
However, small-cap growth ETFs performed better, returning 21.23% (HealthShares Diagnostics HHD) to -34.25% (HealthShares Emerging Cancer HHJ), although the majority were still in negative territory.
Additionally, some ETF families are bringing out new small-cap emerging markets ETFs. WisdomTree's newest fundamentally-weighted Small Cap Dividend offering trades under the symbol DGS on the NYSEArca exchange.
Pay Attention to the ETF Family and Index
Barclays and State Street are the oldest players in the small-cap ETF arena, but many other ETF families have joined the crowd, including Vanguard, Rydex, WisdomTree, PowerShares and ProShares. That gives investors plenty of choices, but be aware that some of the newer families and ETFs may not gather sufficient assets to survive in this burgeoning market. Just recently, Claymore closed the doors on 11 of its ETFs.
Next, to effectively evaluate your ETF choices, learning more about the indexes they track would be very worthwhile. Here are just a couple of examples:
The S&P SmallCap 600 Index is comprised of 600 small-cap stocks. The index bases its criteria on size as well as financial viability, liquidity, adequate float size and other trading requirements. And as a market-weighted index, larger companies will have greater influence on its performance than smaller ones.
The smallest 2,000 securities in the Russell 3000 make up the Russell 2000 index, and represent just 3% of the value of the overall market. The selection process is quantitative - using market cap exclusively - compared to the more qualitative Standard & Poor's.
Although the small-cap market is more volatile than large- and mid-cap stocks, the returns often make that volatility worthwhile. But caution is the byword here. Just make sure you know exactly what you are investing in, keep a close eye on your ETFs, as well as the stocks that go into the ETF, and keep them to a reasonable portion of your portfolio.
As long as you are careful, there's no reason not to enjoy adding some interesting small-cap stock ETFs to your holdings.
his 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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