Much Ado About Microcaps

August 18, 2005

Two micro-cap ETFs hit the market in the past week, and at least one more is on the way. Here’s how the major micro-cap indexes and funds compare.

Micro-cap stocks may be small, but they've rewarded investors with some pretty large returns recently.  According to the Frank Russell Company (Russell), micro-cap stocks outperformed their small-cap peers over the past four years by almost thirty percent, returning 73.6 percent vs. 43.8 percent through March 2005.

Time and the markets will tell us if this level of performance keeps up, and for how long.

Still, those sorts of gaudy numbers are like candy to both investors and fund providers - no one can resist such strong performance - and it seems like hardly a week passes that some new micro-cap index, mutual fund or exchange-traded fund (ETF) hits the market. 

In fact, Dow Jones Wilshire, MSCI, Russell and Zack's Investment Research have all rolled out new micro-cap indexes over the past year, while Barclays Global Investors (BGI) and PowerShares have both launched micro-cap ETFs in the past week!  A third ETF, from First Trust Advisors and based on the Dow Jones Select MicroCap index is expected to launch soon.

Why all the excitement, you ask?  And which micro-cap index offers the best exposure for investors?  This article takes a look.

A New Asset Class Means Wide Discrepancies Within The Indexes

The first thing to understand about micro-cap stocks is that serious interest in them as a separate asset class is a relatively new phenomenon.  Dominated by insiders, inaccessible to most institutional investors and lacking in research coverage, micro-cap stocks have historically flown below the radar of serious investors. 

In fact, the very idea of separating out micro-caps from small-caps is relatively new.   The micro-cap indexes launched in the past year were the first such indexes ever launched by major index providers. Even today, most self-described "micro-cap" fund managers use a small-cap index as their benchmark - a major problem considering how differently the two sectors behave.

The relative novelty of the idea of a "micro-cap sector" means that there is a heated debate in the indexing community today about how best to define the group.  Unlike large and small-cap stocks, where indexers generally agree on the appropriate capitalization range (within a margin of error), the market capitalization cut-offs for different micro-cap indexes vary by more than 100 percent. That makes choosing the right index (and fund) especially important.

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