By Richard Bloch
A comment by Bloominonion on my post about “slushy stocks” suggests that the recent negative press on ETFs is way overblown:
I always wonder who is funding research that focuses negative attention on ETFs without mentioning the mutual funds that trade in the same space. ETFs with their low fees and better performance are very disruptive to the status quo in mutual fund land.
For the most part, I tend to agree. But my post focused mostly on the iShares Russell Microcap ETF (IWC), which seeks to track the smallest 3% of stocks in terms of market capitalization. As Bloominonion explains:
Index-based investing in microcaps makes sense too, given the thin or non-existent analyst coverage at that capitalization, which precludes stockpicking. Morningstar has been saying this for years, and they have more credibility than whoever Kaufman Foundation is.
Here’s where I disagree with Bloominonion. I don’t think microcap investing precludes stockpicking. On the contrary, I think it’s absolutely essential.
Bloominonion is correct that these stocks aren’t widely covered by analysts. But if you happen to know a great deal about a specific microcap company, that knowledge could represent an investment edge.
Experience and knowledge: An extra dose of alpha
We all come to the markets with specific knowledge, expertise, and experiences.
For example, some of us may have studied geology, or know a group of friends in the publishing industry, or perhaps have worked for many years as a restaurant owner.
These experiences and relationships could give us an edge over other investors who may know little or nothing about these industries and companies. So in a sense, our life experience represents an extra dose of potential alpha where picking stocks instead of investing in an ETF makes sense.
One of the microcap stocks on the list I published is Einstein Noah Restaurant Group, Inc. (BAGL) – a company with a market cap of about $208 million.
Let’s say I happen to know a great deal about the bagel business, or perhaps even know some of the key executives at the company. If the fundamentals seem to make sense, wouldn’t it make sense for me to buy this stock instead of investing in a microcap ETF of 1,000+ companies?
Just to be clear, I’m only suggesting this approach if you already have a wealth of knowledge about a specific company or industry. Otherwise, the extensive time needed to get up to speed on how the bagel restaurant sector works might not be worth the effort.
By the way, when I brought up this idea before, I was accused by one commenter as suggesting that ETFs are only for stupid people.
That’s not my opinion at all, but one investment approach does not meet all needs. For example, I happen to know more about semiconductors than biotech, which means I’d be more inclined to pick stocks in the semiconductor sector and use an ETF for my biotech exposure.
But that’s just me. Another investor may have the opposite view – using an ETF for semiconductor exposure and picking specific biotech stocks.
What happens to microcap companies followed by IWC?
As it turns out, I really don’t know much about the bagel business, or BAGL. I just picked it as an example.
But if I did know something about the bagel business, and if I did choose to invest in BAGL, I wouldn’t feel the need to diversify by owning other microcap companies. I’d probably look for diversification elsewhere.
Maybe I’m missing something, but companies in the Russell Microcap Index that are destined for greatness would move out of that index once they leave the bottom 3% of all stocks in terms of market cap. Right?
And any new stocks in the index would either be newly established companies or stocks that have moved down to the bottom 3%.
So I don’t see much benefit in owning a microcap ETF where no one stock amounts to more than 0.36% of its holdings.
As for other ETFs, I think Bloominonion is right: they represent a great inexpensive way to diversify – either by market cap or sector.
Want to overweight or underweight your exposure to large tech companies, smaller regional banks, the midcap sector? There are ETFs for that.
But I’ve never heard anyone say, “I think I need exposure to stocks in the bottom 3% of the market.” I’m not knocking those stocks on a case-by-case basis, but for this asset class, I just don’t think broad diversification makes a lot of sense.
