November 18, 2005

The Microcap Universe Expands

Until recently, investors who wanted to own shares of the smallest U.S. companies through exchange-traded funds had no options. But since September, they've had three.

Although they all focus on very small stocks, the new offerings -- the iShares Russell Microcap Index Fund (IWC), the First Trust Dow Jones Select MicroCap Fund (FDM), and the PowerShares ETF-Zacks MicroCap Fund (PZI) -- differ in their investment approaches and holdings.

The $71 million iShares ETF introduced by Barclays Global Investors tries to match as closely as possible the performance of its benchmark, the Russell Microcap index.

The fund's bogey contains about 2,000 stocks, but Barclays narrows that down to about 1,200, seeking those that are the most representative of the index and that can be traded the most easily without significantly affecting their prices.

"The focus here is on liquidity," said Patrick O'Connor, a senior portfolio manager at Barclays who heads the team that oversees the ETF. A company's financial fundamentals are not a consideration for gaining entry into the fund, he said.

That's not the case with First Trust's ETF. Companies judged to be in poor health are excluded from the $35 million fund, which holds about 300 stocks. It looks at things like profit margins, stock valuations and total returns.

The $87 million PowerShares fund, which owns around 330 stocks, also operates more actively. Like other ETFs offered by the company, Zacks Microcap tracks an index composed of stocks seen as having the greatest potential to outperform a passive benchmark as well as actively managed funds.

Sectors favored by the three funds can also vary. Information technology companies account for about 22% of the PowerShares fund's portfolio. The iShares fund has roughly the same percentage in financial services companies. (Sector holdings for the First Trust fund were not immediately available.)

The funds do, however, have the same expense ratio: 0.60%. That's much lower than the 1.87% expense ratio sported by the average micro-cap mutual fund.

In debuting the ETFs, fund industry observers said the three companies were trying to take advantage of investors' thirst for small-cap stocks, which they noted have performed better than large-caps over the last few years. Micro-cap stocks are generally defined as those of companies with market capitalizations of $350 million or less.

Shauna Ginsberg, a research analyst with fund tracker Financial Research Corp., said the companies are also trying to leverage the popularity of ETFs, whose assets have swelled in recent years. Unlike mutual funds, ETFs trade throughout the day and can be sold short.

Micro-cap funds saw cash inflows of $191 million through the end of September this year, FRC said. That followed outflows of $664 million in 2004, and $771 million in 2003.

Only a relative handful of mutual funds invest in micro-cap stocks. There are currently 41 such funds, not including multiple share classes, according to Standard & Poor's data, and many are closed to new investors. Concerns about liquidity frequently leads fund companies to shut small and micro-cap funds when their asset levels grow too large.

While there aren't many mutual funds or ETFs that invest in micro-caps, people who invest in those stocks can reap big rewards, observers note. Micro-cap mutual funds returned 14.9% on average for the 12-month period through the end of October. By comparison, the S&P 500 index, which holds large companies, rose 8.7% during that span.

Small companies can grow sales and earnings much faster than big ones, which can boost their share prices. They also tend not to be widely followed by brokerage houses, so investors who do their homework diligently on these stocks may be able to cash in. Small stocks also can take off when Wall Street analysts begin tracking and touting them.

But small- and micro-cap stocks can also be very volatile, so they can fall as quickly and as far as they rise, observers point out.

Because of their potential volatility, investors should limit their investments in micro-cap stocks to about 5% of their portfolios, said Rosanne Pane, mutual fund strategist at Standard & Poor's.

Market watchers at Standard & Poor's have said in recent months that they expect investors to begin returning to large-cap stocks at some point in 2006 if interest rates and inflation increase and the U.S. economy cools.

"Smaller companies have outperformed over the last few years and the larger cap companies have underperformed," said Alec Young, an equity market strategist with Standard & Poor's. "And we're looking for that to shift as this bull market ages and the economic cycle ages."

Microcap ETFs

October Return (%)

Assets (mil.)*

Expense Ratio (%)

iShares Russell Microcap Index Fund (IWC)

-3.3

$70.9

0.60%

First Trust Dow Jones Sel MicroCap Fund (FDM)

-1.3

$34.9

0.60%

PowerShares ETF-Zacks MicroCap (PZI)

-3.8

$86.7

0.60%

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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