Small Cap ETFs In a Large Cap Economy

For six years, small company stocks have dominated the performance game; that is, larger companies have been struggling throughout the 21st century to claim a place atop the leader board.

So far, in 2007, larger company holdings have outgained their smaller counterparts. And the big boys have done so with less volatility.

Nevertheless, one might not necessarily wish to shift all of his/her assets away from smaller issues. Perhaps there may be some wisdom in locating the best small-cap exchange-traded fund for a slower growth, maturing bull market economy.

Rather than examine every small-cap ETF -- the similarities and overlap are too numerous -- I focused on 3 core themes.

Specifically, I wanted to see whether a market-cap value-oriented index, an earnings-based index or a "stylistic," non-traditional small index possessed a significant edge.

The ETFs in question do not have an adequate history to draw lengthy conclusions. That said, it may be valuable to take a look at the last 3 months... as each index has had the opportunity to recover from the February market lows.

What makes the Powershares Dynamic Small Cap Value Portfolio (PWY) interesting is not the fact that it has a 3%-5% point advantage on its peers over the last 3 months; rather, it is intriguing because it has a lower price-to earnings-ratio than the other exchange-traded offerings and that it has a 45% weighting in financial companies. What this may be indicating is that, while PWY may prove to a bigger value than its competitors, it is doing so at the risk of overexposure to one segment (financials) of the domestic economy.

The more traditional small-cap value barometer, the iShares Small Cap 600 Value Index (IJS) has a far more substantial track record than those mentioned here. And while its price-to-earnings ratio might clock in a 17.52, this is by no means high. Moreover, IJS covets a lower cost, greater liquidity and higher dividend in this small-cap space.

Perhaps my least favorite of the 3 would be Wisdom Tree Small Cap Earnings Index Fund (EES). Granted, it has better diversification across segments of the economy than PWY. Yet I would expect an earnings-based fund like EES to have performed far better than it had in the better-than-anticipated April-May earnings season. I might also expect EES back-testing data to offer something better in the way of returns than the IJS; however, IJS is more competitive in performance and somewhat similar on risk measures.

Again, I might emphasize that these observations are quite limited in nature; still, if one is inclined to maintain any small-company exposure in the current bull market environment, he might have the best risk-adjusted results with the long-established, no-frills, highly liquid, IJS.

EES, IJS, PWY 3 month chart:

Disclosure Statement: As a Registered Investment Advisor, Pacific Park Financial, Inc. may hold positions in the ETFs, mutual funds and/or index funds mentioned above.

Comments

[Josh Stern:]

I've long been a fan of equal weighted rather than market cap weighted indices, and I use the ValueLine arithemetic index as my benchmark - finance.yahoo.com/char...=^vay;range=my;compare...

But the disadvantage of equal weighting in the small cap space is the sheer numerosity of banks and other financials which results in an "overweighting" to financials by naive strategies - this is undesirable not because it differs from the S&P500 weighting but because it needlessly reduces statistical diversification. There is definitely room in the market for passively or quantitatively managed small cap funds that simultaneously work to optimize the Sortino ratio of the overall portfolio based on stastistical and/or industry diversification.

2007 May 31 10:46 AM

[athenian:]

As an aside to this issue, it seems from the PWY chart that it's had about an 8% increase over the three months. I hold many ETFs that are are up about this amount or more over the same period. Unfortunately, my home currency is the Canadian dollar which has appreciated over 7% against the US dollar in the last 45 days. I'm running hard just to stay in the same place. Meanwhile, I also have carrying costs...
It looks as though the US dollar will continue to weaken, although not perhaps to the same extent. Does anyone have a suggestion?

2007 May 31 11:41 AM

[Beta Hog:]

I would suggest that you base your ETF investment decisions on a currency-converted basis to avoid the problem outlined, as we do ... however, that will depend on how you make your decisions on which ETFs to own that you don't describe ...

2007 May 31 01:47 PM