The widely observed Russell 2000 Index jumped nearly 2% on Wednesday, prompting talk that smaller stocks could be ready to rally anew.
Whether substantial upside from small caps materializes remains to be seen. What is clear, however, is that asset allocators want more exposure to smaller stocks, including micro caps. That general trend could benefit financial assets like the Invesco S&P SmallCap Quality ETF (XSHQ).
XSHQ, which recently turned four years old, follows the S&P SmallCap 600 Quality Index. The fund is worth considering for investors that want small cap exposure without some of the risks associated with embracing a basket of broadly unprofitable names.
In other words, XSHQ gets conservative investors in the small cap door at a time when professional market participants are bullish on smaller stocks. A new survey by the MBH Corporation indicates 78% of money managers and other institutional investors believe small and micro caps will continue topping large cap equities. Those polled manage a combined $230 billion in assets.
“The research found that 84% of professional investors in the US believe micro and small caps are currently an attractive investment opportunity, and over the next 12 months 72% expect investors to increase their exposure to these sectors,” according to MBH. “Over one in six anticipate they will ‘significantly’ increase their allocation, and only 3% predict investors will reduce their level of investment in micro and small caps.”
Adding a Quality Overlay
While that’s a bullish assessment for smaller stocks, investors may still want to prioritize quality in this space. XSHQ accomplishes that by weaving return on equity, accruals ratio, and financial leverage ratio into its methodology. Those metrics can help investors spot profitable smaller companies that are best positioned for long-term upside.
Those are important traits as investors often use smaller stocks as avenues for reducing correlations to large caps.
MBH research “found that one of the main attractions of micro and small caps is that they have low correlations with large caps,” according to the survey. “In the current market environment, 78% of US based professional investors say this is an increasingly attractive feature. Over the next three years, 17% expect micro caps to become even less correlated to large caps, but 24% predict they will become more aligned.”
XSHQ holds 119 stocks, 53% of which hail from the industrial and financial services sectors, making it an ideal play for an environment favoring cyclical names.
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