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Why the Time Is Now for Small-Cap and Micro-Cap ETFs

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Market liquidity in micro-cap stocks will get better if the general market continues to improve and the public's risk appetite grows.

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Micro-Cap ETFs as a High Beta Trade.

Micro-cap ETFs have outperformed the S&P 500 Index in the last year, and in shorter time periods, such as over the last three months and six month periods. Micro-caps have good price momentum and their price/earnings ratios are still reasonable, making them not appear to be overbought. Two that look attractive are the Guggenheim Wilshire Micro-Cap ETF (NYSEARCA:WMCR), and the PowerShares Zacks Micro Cap Portfolio (NYSEARCA:PZI).

The Guggenheim Wilshire US Micro Cap ETF has exposure to about 800 securities, and no one company makes up more than about 1.1% of assets. Financials are the largest sector at about 26% of total assets, and health care makes up about 23%. Tech has a large allocation at about 18%. WMCR has a low price/earnings multiple, at about 13 times.

PZI tracks the Zacks Micro Cap Index, and is designed to identify the micro-cap stocks with the greatest potential to outperform passive benchmark micro-cap indexes and actively managed US micro-cap strategies. Its index holds just 400 names. Financials comprise the biggest sector of the index at about 26%, and tech, industrials and consumer discretionary each comprise about 14% of total assets. PZI sells at a fairly rich earnings multiple of about 20 times.

Trading Micro-Cap ETFs.

Buying and selling stocks to keep within an index mandate is usually not a problem for ETF managers because markets are generally liquid. A problem with micro-cap ETFs is that there could be a liquidity problem in that ETF indexes usually contain stocks that have limited floats, which equates to limited liquidity in the marketplace. When an ETF sponsor has to buy and sell stocks to rebalance to keep within its models, the sponsors cannot just drop market orders. If the managers put in market orders they could drive up or down the market price, and end up buying or selling stock outside of the stock's realistic market price.

Market liquidity in micro-cap stocks will get better if the general market continues to improve and the public's risk appetite grows. But at times when markets are not going up, liquidity is a problem, and special handling will be necessary. The problem is mitigated somewhat by the large amount of stocks that are in the index baskets, giving diversity that is common to micro-cap ETFs.

Paul Weisbruch of Street One Financial is a liquidity provider for stocks and ETFs, and he works at making it possible for sponsors and traders to trade what are sometimes illiquid securities. Weisbruch says that small- and micro-cap ETFs are back in focus because of their potential to deliver growth. Weisbruch says, "In 2013, we have certainly noticed a pick-up in activity in small-cap sector oriented funds, such as PSCT, in addition to increasing allocations being made to the micro-cap specific names as well. This, along with an increase in activity and a lift in performance in country specific "small cap" products, such as iShares MSCI Brazil Small Cap Index ETF (NYSEARCA:EWZS), shows us that investors who may have sat on the sidelines during the past few years as the equity markets have rallied are embracing higher beta segments of the market, whether they be US domestic or even foreign based small- and micro-cap equity names, via an assortment of newer and innovative ETFs."

Editor's Note: Max Isaacman is the author of Blizzard of Money, Winning with ETF Strategies, Investing with Intelligent ETFs, How to Be an Index Investor, and The NASDAQ Investor.
Author and/or his clients hold shares of PSCT, PZI.
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