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PowerShares Plans Small Cap Sector ETFs

by Michael Johnston on January 20, 2010 | ETFs Mentioned: IJH • IJR • IVV • XLE

After launching more than 120 new funds last year, the ETF industry seems poised to continue its rapid growth in 2010. Numerous issuers have big plans for this year, with the number of new product launches expected to once again exceed 100 and perhaps even top last year’s results. A recent SEC filing shed some light on PowerShares’ plans for future growth, revealing that the Chicagoland issuer may be looking to launch as many as ten sector-specific small cap ETFs. The funds highlighted in the filing include:

PowerShares S&P SmallCap Consumer Discretionary Portfolio
PowerShares S&P SmallCap Consumer Staples Portfolio
PowerShares S&P SmallCap Energy Portfolio
PowerShares S&P SmallCap Financials Portfolio
PowerShares S&P SmallCap Health Care Portfolio
PowerShares S&P SmallCap Industrials Portfolio
PowerShares S&P SmallCap Information Technology Portfolio
PowerShares S&P SmallCap Materials Portfolio
PowerShares S&P SmallCap Telecommunication Services Portfolio
PowerShares S&P SmallCap Utilities Portfolio

Each of the proposed funds would be linked to a subset of the S&P SmallCap 600 Index, a benchmark measuring the performance of companies with a market capitalization between $250 million and $1.2 billion.

Unique Risk Profile

Historical Performance
ETF	1 Year	3 Year	5 Year
S&P 500 Index Fund (IVV)	26.4%	-5.6%	0.4%
S&P MidCap 400 Index Fund (IJH)	37.9%	-1.9%	3.2%
S&P SmallCap 600 Index Fund (IJR)	25.8%	-4.9%	1.2%
Source: ishares.com as of 12.31.2009

Because they generally have shorter operating histories and smaller customer bases, small cap companies are generally perceived to be more volatile and risky than big names, but may also offer superior growth prospects.

Small cap ETFs generally exhibit a strong correlation with large and mid cap stocks, but as shown in the adjacent table, the differences in returns between stocks of different sizes can be material at times. The significant differences in historical performance show that this group of equities clearly maintains a unique risk and return profile relative to larger stocks.

Another potential attraction of targeted small cap ETFs is the lack of security concentration. Because most large cap ETFs are linked to cap-weighted benchmarks, mega-cap firms often make up a significant portion of the total fund. For example, the Energy Select Sector SPDR Fund (XLE) has about 40 holdings, but the ten largest account for more than 60% of assets. The concentration of a few big names is often mitigated significantly in small cap funds.

Small cap ETFs offering exposure to international equity markets have become increasingly popular in recent months. Funds focusing on small caps in Brazil, China, Japan, and the EAFE region are already available, and all of these ETFs outperformed their large cap peers by a wide margin in 2009 (see the complete results in this study).

Next Wave Of Growth

Exposure to small cap equities through ETFs is nothing new. According to our ETF screener, there are currently 50 U.S.-listed ETFs offering exposure to this segment of the market, but the vast majority of these product offer broad based exposure, diversifying holdings across all sectors of the economy. The proposed PowerShares funds would be the first to offer targeted exposure to domestic small cap companies. The funds would also represent a shift in PowerShares’ product line towards beta products. Historically, PowerShares has promoted itself as the leader of the “intelligent ETF revolution,” hanging its hat on a line of Dynamic ETFs that use proprietary quantitative analysis techniques to identify companies expected to outperform the broad markets (read more about these funds and other “enhanced” indexing strategies in this feature).

Disclosure: No positions at time of writing.