iShares Russell Micro-Cap ETF: Compelling at Current Levels

| About: iShares Micro-Cap (IWC)

The recent weakness in the markets has been particularly painful for the smallest of stocks. While many investors consider "Small-Cap" to be the smallest division of stocks by market cap, there are actually indices for even smaller stocks, which are known as Micro-Caps. Russell has a 2000-stock index that includes the bottom 1000 of the Russell 2000 (typically the benchmark for "Small-Cap") and the next 1000 stocks. This index is up only 1.4% YTD in 2011, having retraced substantially all of its gains that had left it up 8% or so through the end of April. A deeper look reveals that the "Value" component of the Russell 2000 is actually driving this weakness.

I believe that the weakness in Micro-Caps is a function of individual investor sentiment declining more rapidly than institutional investor sentiment. If you believe, as I do, that the retail investor will be back soon, Micro-Caps might be the way to go. Additionally, in a heightened M&A environment, we could see some above-market performance as acquisitions drive up prices.

I have been looking over the ETFs, as I am considering adding one to my Sector Selector ETF Model, which I launched 5 weeks ago. The one that I like best is iShares Russell Microcap ETF (NYSEARCA:IWC). It has good liquidity, with almost $500mm in assets and over $5mm per day in trading volume. The expense ratio is higher than for other passive ETFs at 0.71%, which is somewhat disappointing. There are 1330 holdings, and the ETF first launched 6 years ago.

Many have suggested that mutual funds may be a better way to invest in Micro-Caps and I would certainly agree. Of course, even better is to just pick the stocks yourself, which is what I do. If, though, you want to use an ETF, I think that IWC is the best due to superior liquidity and construction.

Here is a link to the iShares website. There, you will see that the largest holding is just 0.56% of the total fund composition with the Top 10 making up just 3.8%. The median size is $180mm. The sector breakdown reveals a potential source of recent weakness, as Financials comprise almost 1/4 of the holdings. Healthcare and Technology are each about 17%.

Here is a chart of the past 5 years:

click to enlarge

Note the divergence between this chart and the Small-Caps, which took out their all-time high earlier this year. The light blue line is a relative strength line compared to the S&P 500 - it has been pretty flat since the peak in the market in 2010, with a recovery following a big dip in the summer last year (with weakness in the market). Clearly, IWC is more volatile than the market, so part of my call in liking this market cap slice is market-directional.

I like Micro-Caps and IWC at the same price (essentially) as they began the year. While an ETF may not be the best way to invest in the sector, I do believe that IWC offers good tracking for the sector, although it is somewhat expensive.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.