New Small-Cap ETFs Give Investors Fresh Tools

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April 19, 2010
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A slew of small-cap ETFs that have hit the market in the past month are giving investors a whole new array of tools for picking the most prospective countries or industries as the global economic recovery takes shape and gathers momentum.

More than a dozen new high-risk/high-reward small-cap ETFs have been launched by major firms such as PowerShares, Van Eck and IndexIQ in the past month, adding to a growing roster of some 40
U.S.
small-cap ETFs that ETF providers hope will lead equities higher as the economy recovers from its worst downturn since the 1930s.

Small companies, by nature of their size, are more nimble and can adapt to challenging economic circumstances more quickly than larger companies, analysts and industry sources say. Also, many of the new small-cap ETFs are focused tightly on specific industries, allowing investors to have more distilled access to attractive parts of the economy, and typically at a cheaper price than larger-cap names.

“Small-caps traditionally lead the way out of a recession,” Adam Patti, president of ETF firm IndexIQ, said in a telephone interview. Patti’s Rye Brook, N.Y.-based company is in the process of rolling out 13 country-specific small-cap ETFs targeting Asian economies as well as commodities.

Investors seem to be buying the argument. As of March 31, assets allocated to
U.S.
small-cap ETFs had grown 87 percent from a year ago, compared with 43 percent growth in large-cap ETFs in the same period, according to data gathered by Morningstar, the Chicago-based investment research firm.

Investing in smaller companies is riskier, but can also provide bigger returns, according to Paul Louie, director of small/mid-cap portfolio management for Richmond, Va.-based Riverfront Investment Group. Also, ETFs eliminate single-company risk because they typically hold all the stocks that are in the index on which the fund is based.

“A small-cap ETF should help smooth out some of that inherent volatility,” Louie said. So investors can have it both ways with the new batch of funds to the extent that sector funds give them tools to hone in on particularly prospective corners of the investable universe. Riverfront designs and markets investment portfolios to financial advisers, and has $1.8 billion in assets under management, $1 billion of which is allocated to ETFs.

Leading The Market

The U.S. economic recovery isn’t likely to be led by consumers because high levels of debt are weighing on their pocketbooks, Sam Stovall, chief investment officer at New York-based Standard & Poor’s, says. Instead, small-cap companies are likely to spur new growth through job creation and mergers and acquisitions.

Some of the most popular small-cap ETFs have year-to-date returns of about 10 percent. Those include the nearly 10-year-old $14-billion iShares Russell 2000 Index (NYSEArca: IWM), which gained roughly 28 percent in 2009, as well as iShares’ other offering, their $6-billion S&P SmallCap 600 (NYSEArca: IJR).

Vanguard’s $3.2 billion Small Cap ETF (NYSEArca: VB), the cheapest of the three, has returned almost 13 percent so far this year following 36 percent in gains in 2009, according to Morningstar. It was launched six years ago.

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