Micro Cap ETFs: Time To Think Small?

by on October 17, 2011 | ETFs Mentioned:

Although the economy remains weak in the U.S., it is arguably better here than in many other spots around the world. Inflationary concerns and extreme levels of volatility are rocking emerging markets while many developed markets are facing debt crises on a seemingly daily basis. Yet, investors still remain skeptical of the American stock market as a whole, preferring to keep their assets in low risk options instead. Unsurprisingly, this fear of risk has led many into large cap equities as a haven from the storm, leaving many investors to forget about smaller, and often times more volatile, market cap levels. While this may be fine in a high risk environment, investors could miss out on some of the biggest gains should the economy stabilize and push broad markets higher.

In fact, after the market bottomed in early 2009, small and mid cap securities greatly outperformed their larger counterparts, outgaining them by a wide margin in the period. While this has reversed in recent months, it remains clear that small caps outperform in bull markets and lag behind in bears. Although a number of funds in the space could offer decent exposure to this corner of the market, there is likely one ultra-small corner that many investors have overlooked; micro caps.

Micro caps are generally considered to be firms that have a market capitalization below $300 million but at least $50 million on the low end. Although many ‘penny stocks’ fall into this category, there are still a great deal of small and stable businesses in the space that obviously still have plenty of room to grow in the coming years. Furthermore, investors should also consider their own asset allocation profiles as another reason to think about micro cap exposure. Pretty much every investor has exposure to large caps and, to a lesser extent, small caps as well, but many forget about the ultra small securities that make up the micro cap segment of the market. Lastly, the use of ETFs in the space drastically reduces risk as company specific problems are more or less non-existent in many of these funds, ensuring that when one particular company falls it doesn’t have a huge impact on the overall return of the fund [see The Definitive Guide To Micro Cap Investing].

In light of  this, some investors would probably be well served by looking at some of the ETFs tracking the space. Currently, there are three funds tagged as ‘micro cap ETFs’ in our proprietary database with total assets of about $440 million. Below, we briefly discuss these three products as well as some of the key factors to consider for those looking to make a play on this small, but important, corner of the market:

iShares Russell Microcap Index Fund (IWC)

IWC is the original and most popular micro cap ETF having debuted in August of 2005. In total, the fund holds 1,418 securities in total and puts just 2.7% in its top ten suggesting impressive levels of diversification from an individual security perspective. In terms of sectors, financial services take up a large chunk at just under 26.4% and this is followed by double digit weightings to firms in the health care, tech, durable goods, and consumer discretionary spaces. Meanwhile, capital intensive industries, such as utilities and energy, make up small allocations in the fund [Beyond IWM: Five Intriguing Small Cap ETFs].

IWC charges investors 67 basis points a year in fees but pays out a relatively high dividend of 1.55% in 30 Day SEC terms. While this may suggest a value tilt, investors should also note that the product has a beta of 1.5 and a PE of 21.5, meaning that it may be closer to growth than anything.

Guggenheim Wilshire Micro-Cap ETF (WMCR)

This fund from Guggenheim tracks the Wilshire U.S. Micro Cap Index which is a float-adjusted, market capitalization-weighted benchmark of the issues ranked below 2,500 by market capitalization of the Wilshire 5000 Total Market Index. In total, the fund has exposure to 822 securities with no one company making up more than 1.1% of assets. From a sector perspective, financials are the leader at 25.7% although health care makes up a good chunk as well with 22.7% of total assets. Tech also has a sizable allocation at 17.8%, while telecoms and utilities are laggards, making up less than 2% combined in the fund [Compare any two ETFs with our Free ETF Comparison Tool].

WMCR is the cost leader in the space as it charges investors just 50 basis points a year in fees. The product has a much lower PE multiple than its iShares counterpart, as the figure comes in at just 13.0. With that being said, investors should note that the fund still has a beta of 1.3 suggesting that it is more volatile than the overall market.

PowerShares Zacks Micro Cap Portfolio (PZI)

PZI is the final micro cap ETF on the list, tracking the Zacks Micro Cap Index which is designed to identify a group of micro cap stocks with the greatest potential to outperform passive benchmark micro cap indexes and other actively managed U.S. micro cap strategies. Thanks to this methodology, the fund holds far less securities than either of the other two on the list, just 400 in total. In terms of sector exposure, financials again take up the top spot at just over 26.3% followed by tech, industrials and consumer discretionary all around 15% of total assets. Once again, utilities and telecoms hardly make up anything in the fund, combining to make up less than 2% of total assets [see more on PZI's Fact Sheet].

Despite this more ‘active’ focus, the fund’s expenses are in line with other products in the space, charging investors 60 basis points a year in fees. For investors looking for yield, the fund does an average job as the 30 Day SEC yield comes in at just over 1.0%. With that being said, the PE of the fund is just under 14.6 while the beta is close to 1.6, suggesting that it offers a nice mix between value and growth.

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Disclosure: No positions at time of writing.