Many investors choose to build their portfolios around core holdings in large and mega cap equities, investing in the S&P 500 or a similar benchmark. Beyond “blue chips,” many round out portfolio holdings with more moderate allocations to mid cap and small cap equities as a means of achieving diversification and potentially enhancing returns. But domestic equity exposure doesn’t stop with the Russell 3000. There are over 9,000 publicly traded companies currently available to U.S. investors, including thousands of micro cap equities. While these “smallest of the small” fall under the umbrella of domestic equities, they may have a unique risk and return profile that warrants a separate allocation in investor portfolios.
Micro Caps 101
A micro cap firm can generally be defined as a company that has a market capitalization of between $50 and $300 million (”small caps” can have a market capitalization of up to $2 billion). Micro caps tend to be uncorrelated with their larger peers; they can have a correlation as low as 0.60 with the S&P 500. Micro caps can exhibit volatile returns: among the major holdings of certain micro cap ETFs, year-to-date returns ranged from negative 41% to more than 1,100%.
Micro caps tend to fly under the radar and usually trade on either the NASDAQ, OTC BB, or the pink sheets as opposed to the more prestigious NYSE. While most are unknown quantities, there are some well known names that fall into this bucket, such as Boston Beer Company (the maker of Sam Adams), La-Z-Boy, and even US Airways. Despite the name brand recognition of a select few, all of the securities in this fund have tiny market capitalization levels, they are among the smallest firms publicly traded more generally referred to as the micro caps.
Given the volatility that can come along with micro cap equities, many investors prefer to gain exposure to this sub-class through ETFs. Because these funds spread exposure across dozens of individual holdings, beta is captured while minimizing company-specific risk. There are currently a multitude of ETFs tracking various subsets of the S&P 500 and other large cap indexes but there are only three ETFs that currently track this often overlooked slice of the market.
The Sky Is the Limit
The main draw to micro cap ETFs is their incredible growth potential. Because many publicly-traded companies at early phases of their life cycle are classified as micro caps, the potential for triple digit returns is perhaps greater than large cap investing. Of the three micro cap ETFs highlighted below, two funds had seven equities from their top 25 holdings increase by more than 250% in 2009 while the third had two equities increase by at least the same amount. Of course no returns come without commensurate risk. Many micro caps fail or lose significant value as well, resulting in a high dispersion of realized returns.
For every company that skyrockets out of the micro cap world and into the mid and large cap universe, there are plenty that stay grounded in their current class (or worse). Since many micro cap firms are in the red, bankruptcies are not uncommon in this volatile asset class. Price-to-earnings ratios for many on many of the holdings are not meaningful, given negative or near-zero earnings.
Characteristics of Micro Cap ETFs
- High Turnover: Due to the nature of the asset class, component companies are likely to grow too big to be included or disappear altogether (i.e., bankruptcy or delisting). This leads to an ever changing security allocation picture; one quarter a fund might have a high weighting towards financials and the next industrials — it can be very unpredictable over any significant period of time.
- Assets Spread Thin: Since most companies in the micro cap indexes are very small, too much ETF money in any one company could create a price disruption far easier than in other asset classes. ETFs are forced to buy into hundreds of companies in order to make sure that they do not have a large or even controlling interest in any firms. They must also be able to stay liquid — too large of a position in a very small and thinly traded security could pose a problem for an ETF that needs to liquidate that position. This lack of asset concentration will dilute the gains of a big winner but will also help to protect against big losses from a lagging firm.
- Big Risk, Big Reward: Equities in the micro cap class can and often do move double digit percentages in a matter of hours. While this can be great news if the stock is going up, it can be devastating if the shares are going down and value is being eroded on a minute by minute basis.
Micro Cap ETFs
There are currently three options available for investors who are looking to invest in the micro cap market. While similar in some ways, these ETFs also have some big differences, such as allocation strategies. Despite the risks associated with this asset type, all three have offered a great deal of stability in their returns and offer investors a chance to further diversify their equity holdings without greatly expanding their risk.
PowerShares Zacks Micro Cap (NYSEARCA:PZI)
PZI holds 400 different stocks and has an annual turnover of 51%. Just 3.3% of the fund’s total assets are in the top ten holdings, and it is most heavily weighted towards services and underweight in the heavy industries. Although the fund has underperformed its micro cap peers in 2009, it does charge a competitive expense ratio of 0.60%.
iShares Russell Micro Cap Index Fund (NYSEARCA:IWC)
This fund currently holds more than 1,300 stocks and represents the broadest allocation to micro caps currently offered to ETF investors. IWC also maintains the lowest annual turnover of the three at 25%. Like the other micro cap funds, this ETF offers excellent diversification, with just 3.8% of the fund in the top ten holdings. The assets of IWC are most heavily weighted to service companies, with financial service firms making up 22.7% of the fund and energy and utility firms making up under 4% of the fund’s assets. IWC is up 20% in 2009 and charges an expense ratio of 0.68%.
First Trust Dow Jones Select Micro Cap Fund (NYSEARCA:FDM)
First Trust’s Micro Cap fund has the narrowest base of the three with “only” 271 stocks in the fund. FDM has the highest annual turnover rate of the three at 85% and is the most concentrated with almost 8 % of the assets in top ten holdings. The fund is overweight in business services and software while it is is significantly underweight in energy and utility firms. It is up 16.6% in 2009 and charges an expense ratio of 0.60%.