The Best Micro-Cap ETF

December 08, 2009

In micro caps, the small things matter. We get down to details with the funds covering this tiny portion of the market.

 

This article previously appeared in the December issue of ETFR, our subscription-based monthly ETF newsletter. To learn more about ETFR, click here.

 

A lot of investors have an interest in small-cap stocks; for them, it’s not all about the S&P 500. In small-cap territory, they assume, there’s more growth potential.

That’s even truer of stocks that fall below the usual small-cap cutoff point. One could make the argument about so-called micro caps that there’s nowhere to go but up (or possibly blipping out of existence). After all, as of Sept. 30, the Russell MicroCap Index had an average market capitalization of $268 million, and its largest component was $983 million.

But for the index ETF investor, micro caps are a problematic asset class simply because there are not a lot of vehicles that provide focused exposure—just four ETFs in all.

The largest by far is the iShares Russell Microcap Index Fund (NYSE Arca: IWC), which has assets of roughly $290 million. It was launched in August 2005.

IWC’s underlying index covers 2,000 stocks. It consists of the smallest 1,000 stocks in the well-known Russell 2000 Index and the 1,000 stocks falling below those in market capitalization. However, the fund’s portfolio has been optimized to hold 1,317 stocks. The largest holdings are in Dana Holding Corp., 0.47 percent; Schweitzer-Mauduit Intl. Inc., 0.44 percent; Veeco Instruments Inc., 0.39 percent; First Financial Bancorp, 0.32 percent; and ArvinMeritor Inc., 0.32 percent.

IWC charges 68 basis points.

First-Mover Status Is Key

The PowerShares Zacks Micro Cap Portfolio (NYSE Arca: PZI) is a distant second to IWC in terms of assets, with just $47.8 million. Like IWC, it was launched in August 2005, just a few days later, which goes to show how important the first-mover status really is and perhaps how helpful a well-known brand name can be.

PZI tracks an index from Zacks and holds 400 different companies. That’s fewer than IWC, but still, a broad number in the micro-cap space. Interestingly, PZI has an average market capitalization among its components of $355 million, while IWC has an average of $229 million. So IWC clearly skews a bit smaller in its focus.

PZI’s underlying index is designed to target companies that Zacks believes are likely to outperform the broad micro-cap category. Unfortunately, that doesn’t seem to have worked too well for the past couple of years or so. The fund has under-performed IWC year-to-date for 2009 and in 2008 and 2007 as well, according to Morningstar, though it did outperform IWC in 2006.

Its top holdings are U.S. Energy Corp., 0.43 percent; East West Bancorp Inc., 0.42 percent; China Yuchai International Ltd., 0.42 percent; A. H. Belo Corp., 0.40 percent; and Qiao Xing Mobile Communication Co. Ltd., 0.40 percent. It charges a gross expense ratio of 86 basis points, but has expenses capped at 60 basis points.

First Trust offers the third-largest fund in this category, the First Trust Dow Jones Select MicroCap Index Fund (NYSE Arca: FDM). It has roughly $16.8 million in assets and charges an expense ratio of 60 basis points.

 

Like PZI, FDM has a tweaked index methodology that is not based solely on market capitalization. Components are selected based on liquidity and fundamentals from the designated size range, as defined by the two smallest size deciles of stocks listed on the NYSE Arca (though components are selected from both Nasdaq and the NYSE). However, this tweaked methodology has served FDM well—it outperformed the rest of its peer group in 2007 and 2008, and year-to-date is fairly close on the heels of the second-best performer as of the end of October.

FDM has an average market capitalization of $316 million—more than IWC, but less than PZI. FDM also has fewer stocks than either fund—just 270 holdings. Of those, the top five are ATP Oil & Gas Corp, 1.18 percent; Albany International Corp., 0.90 percent; Dollar Financial Corp., 0.82 percent; Evercore Partners Inc., 0.84 percent; and Manhattan Associates, Inc., 0.83 percent.

The final ETF in this asset class is the Claymore/Sabrient Stealth ETF (NYSE Arca: STH). The fund tracks an index of 150 stocks selected from a group of securities—including stocks, ADRs and MLPs—with “little or no Wall Street analyst coverage” based on their growth characteristics. The selection universe of roughly 2,100 securities tends to fall in the small-cap and micro-cap spectrum, with most having market capitalizations of less than $3.5 billion. According to Morningstar, the fund has the highest average market capitalization of this group, at $537 million. At that level, some might question whether it’s truly a micro-cap fund, but we’ve included it here for good measure.

Micro Cap ETFs

The top five holdings include GenCorp Inc., 1.83 percent; Harvest Energy, 1.8 percent; Alexandria Real Estate Equities, 1.43 percent; Omega Healthcare Investor, 1.41 percent; and Baytex Energy Trust, 1.37 percent. The portfolio includes a variety of ADRs (more than 10 percent of the portfolio’s securities), so there is a significant international influence. That doesn’t seem to have helped its performance, however: STH was the worst-performing ETF in the asset class in 2007 and the second-worst in 2008. It’s currently seeing an upturn though, and is in second place, year-to-date.

STH is the smallest fund in this group, with just $3.7 million in assets. It carries an expense ratio of 60 basis points.

So which one should you buy? FDM is a consistent performer, though the time frames are rather narrow. IWC is close on its heels, but IWC is also the most expensive fund in this category, charging 8 more basis points than the rest.

FDM’s main drawback is mainly its lack of significant assets, which could affect tradability, particularly for a micro-cap fund. Given its strong liquidity, broad market coverage and brand name recognition, IWC is a solid, safe bet for most investors. If you think an index that screens stocks for certain features could be a winner in a category like micro caps, where many folks are wary of the risks inherent in these tiny stocks, FDM would likely be your best choice. Should you like this approach and have concerns about FDM’s liquidity, PZI also has a modified methodology and adequate assets, though it has under-performed the others.

STH offers a different twist on the micro-cap universe, with its “neglected stock” strategy and inclusion of ADRs. Unfortunately, so far, stealth hasn’t equaled positive performance for the fund; and with just $3.7 million in assets, we worry that STH could be so stealthy that it disappears …

 

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