From the August 2009 issue of Investment Advisor • Subscribe!

August 1, 2009

The ETF Advisor: Those Outperforming Small Caps

An ETF for nearly every strategy

Small-cap stocks are a thorny problem for investors. With thousands of different issues and little analytical coverage available, it is a difficult and time-consuming task to develop an informed view of the small-cap market, and consequently, few bother. That is too bad, because small-cap stocks do have important differences from large-cap stocks, and their performance can diverge significantly. For this reason, investment strategists usually recommend that some portion of a portfolio's equity holdings be devoted to small-cap stocks: Standard & Poor's Equity Strategy Group currently recommends a 3% portfolio weighting in U.S. small caps in its moderate asset allocation portfolio.

Small-cap stocks tend to outperform large caps during periods of recovery from bear markets, S&P Chief Investment Strategist Sam Stovall says, calculating that in the 12 months following the five bear markets since 1982, small-cap stocks gained an average of 56% compared with 36% for the large-cap stocks of the S&P 500. Small caps have outperformed large caps since stocks hit a low in early March, he says, despite the fact that their price/earnings multiples are not particularly attractive.

Exchange traded funds offer a relatively convenient and cost-effective way to invest in small cap stocks. There were 43 ETFs targeting the small-cap sector at the end of May, according to Investment Company Institute data, compared with 40 focused on mid-cap stocks, 64 on large caps, and 19 "total market" funds.

With so many ETFs vying for attention, there is often a choice of funds even for specific strategies within the small-cap universe. Barclay's iShares Funds has three ETFs tracking both small-cap value (JKL, IWN, IJS) and growth stocks (JKK, IWO, IJT); Invesco PowerShares (PZI), First Trust (FDM), and iShares (IWC) all list ETFs covering the "microcap" subsector of small-cap stocks. There are multiple offerings of ETFs offering leveraged exposure to small-cap stocks (TNA, UWM, SAA, RRY), as well as inverse exposure (TZA, TWM, RWM) for those who want to be against them. (Recall Stovall's argument that small caps tend to underperform large caps during bear markets).

For the truly adventurous, there are several ETFs that give exposure to foreign small-cap stocks, including the Market Vectors Brazil Small-Cap (BRF), the Claymore/AlphaShares China Small Cap Index ETF (HAO), the SPDR S&P International Small Cap (GWX), and the SPDR S&P Emerging Markets Small Cap (EWX).

Judging by trading volume, however, it would seem that investors are most interested in a straightforward exposure to the Russell 2000 index, the most widely followed benchmark of small-cap performance.

The iShares Russell 2000 Index (IWM) is one of just three small-cap ETFs with an "overweight" recommendation from S&P's new qualitative and quantitative ETF assessment tool, which takes into account the outlook for the members of the index which the ETF tracks, as well as historically based measures of cost, risk, and performance. The others are the iShares Russell 2000 Growth Index (IWO), and SPDR Dow Jones Small Cap Growth (DSG).

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