Small Cap ETFs to Consider

By Max Isaacman  OCT 02, 2012 9:50 AM

The last 10 years have been great -- if you were in small caps and some other asset classes.


MINYANVILLE ORIGINAL There really is a bull market somewhere, maybe all the time. It’s been widely reported that the stock market has gone nowhere for 10 years, and that is only partly true, depending on what part of the market you are referring to. That the market has been stuck for the past 10 years is true for many of the big, mature company indexes. Some other parts of the market have done fine. Small caps, for instance, have been in a bull market for the last 10 years.

The iShares S&P SmallCap 600 Index ETF (NYSEARCA:IJR) which replicates the S&P Small-Cap 600 Index (INDEXSP:SP600) has gone up about 140% from May 2000 to Sept 2012, which is a gain of over 10% a year. Also SPDR S&P MidCap 400 ETF (NYSEARCA:MDY) which replicates the S&P Mid-Cap 400 Index (INDEXSP:SP400), has gone up about 8% a year in those same dates, an accumulated return of about 100% . If you were in those asset classes, the last 10 years would not have been a lost decade. The S&P 500 Index (INDEXSP:.INX) in that same period, along with the Nasdaq (INDEXNASDAQ:.IXIC) and many other larger-cap indexes, was essentially flat. (Data is sourced from Yahoo

As well, there are sectors that have done very well over the past 10 years. One of these is the energy sector. The Energy Select Sector SPDR ETF (NYSEARCA:XLE) has gone up over 200% from December 1998 to September 2012. No bear market there, although there were wide swings in that period.

Some sectors have done worse, some much worse, than the S&P 500 Index. One is the financial sector. In the same period that XLE has performed so well, the Financial Select Sector SPDR (NYSEARCA:XLF) has declined about 50%.

Small caps over long periods of time have and probably will continue to outperform bigger cap-sized equities. Small-caps do have periods of substantial decline, and have higher volatility than big- and mid-caps. Keep in mind that parsing the market in this way -- by selecting cap sizes, sectors, regions, and other slices of the market -- is not investing in the overall market, which is dominated by bigger companies and more developed economies. Bigger companies comprise most of the market’s capitalization. Of course, investors don’t think about being in the "market"; they care about making money. Not investing in the “safer” confines of the bigger-cap companies entails taking on more risk, although by staying safe and not slicing and dicing the market for beta, you might be giving up opportunity.

I think choosing asset classes for more beta makes sense, and safety is relative in the market. And market timing, as far as when to be in certain asset classes, trumps any other strategy.  Small caps should be a part of almost any portfolio. The US economy is doing better than much of the rest of the world today, and small caps are tied more to the domestic economy than are big caps, making them a timely buy.

Small Cap ETFs to Consider

Cap-Weighted. The S&P Small-Cap 600 ETF (NYSEARCA:IJR) is the major cap-weighted offering from iShares. There are advantages and disadvantages of cap-weighted ETFs, just as there are tradeoffs in other cap-weighting methods. With cap-weighted you do get the most exposure to the most dominant companies in that asset class, and sometimes this weighting performs the best and sometimes it doesn’t. Cap-weighted indexes are simple, and one of the advantages of it is that the index only makes trades when the index makes changes to its underlying securities, which is not very often. This cuts down on the trading expenses of the ETFs that replicate the index.

Revenue-Weighted. The RevenueShares Small Cap ETF (NYSEARCA:RWJ) is weighted by stocks according to the highest top line revenue generated. These weightings are based on the same stocks that are found in IJR. VTL Associates, the ETF maker, says its studies show that revenue weighted indexes will produce higher returns than cap-weighted indexes over time, and also have a slightly lower beta. One of the reasons VTL uses revenues is because all companies have revenues, and not all companies have other fundamental factors such as net revenues, or dividends, or significant book value. VTL thinks that by using revenue weighting every stock in the S&P Small-Cap Index will be represented fairly, which maintains the breadth of that index. VTL believes that revenue weighted indexing can prevent an investor from being over-weighted in over-priced stocks, because the price of the stocks in the index does not determine the weight that the stocks will have in the index. 

Earnings Weighted.  The WisdomTree Small-Cap Earnings ETF (NYSEARCA:EES) is weighted by measuring the performance of companies that are generating earnings, and are selected from the small-cap segment of the US stock market. The index selects the companies in the bottom 25% of the market capitalization of the WisdomTree Earnings Index. Companies in the index have to be incorporated in the US and listed on US exchanges, and have generated positive cumulative earnings over their most recent four fiscal quarters prior to the latest index measurement date.

Foreign Small Cap Exposure. Most foreign ETFs are dominated by large, multi-national companies that domicile in foreign countries. Small cap stocks, more than big cap stocks, reflect the domestic economy of the countries that they are domiciled in. For instance, Russian small cap stocks will reflect better than big cap stocks the Russian economy and its components therein, and will include sectors such as the consumer discretionary sector, and the consumer cyclical sector.

So far, the small-cap growth ETFs in foreign countries have not performed as well as the bigger cap ETFs. For instance, iShares Inc (NYSEARCA:EEMS) has underperformed iShares MSCI Emerging Markets Indx (ETF) (NYSEARCA:EEM), and Market Vectors ETF Trust (NYSEARCA:RSXJ) has underperformed Market Vector Russia ETF Trust (NYSEARCA:RSX). This is probably due to the financial problems in Europe and other foreign countries. But at some point the risk environment should improve and there will be better performances in the small-cap foreign asset class.

Foreign stocks generally pay more dividend than US stocks. An ETF to consider for a longer-term value and dividend investment is the WisdomTree Emerging Markets Small-Cap ETF (NYSEARCA:DGS). The new China Dividend Ex-Financial ETF (NYSEARCA:CHXF) from WisdomTree looks interesting for a long term emerging markets investment. About 40% of the ETF is in small- and mid-caps.
My clients and/or I am long DEM, DGS, EEM, IJR, RWJ