Micro-cap ETF soon?

by: David Jackson

Morgan Stanely Capital International (NYSE:MSCI) is about to unveil a new
micro-cap index on Monday, according to Barrons. Wilshire already
offers a U.S micro-cap index, but MSCI will use a different methodology.

Now, the publication of a new index and its underlying methodology
are not generally topics that will excite most investors. But this is
different and important. Here's why.

MSCI has focused on producing indices that are easier to use as
investable products, for example by adopting available-float weighting
instead of market-cap weighting and by implementing ways to reduce the
turnover of index constituents. As a result, Vanguard, for example, has
begun to adopt MSCI float-weighted indices.

This could mean that a micro-cap index exchange-traded fund (ETF) is not far off.
Currently, there are hardly any micro-cap index mutual funds.
Dimensional Fund Advisors (DFA) offers an index fund, but it's not
directly available to retail investors, and hedge fund managers can't
short it. Vanguard has no micro-cap index fund. And critically, there's
no micro-cap ETF.

Why is the availability of a micro-cap ETF so important?
Because both asset allocators and long-short hedge fund managers would
benefit enormously from its availability. Asset allocators need a
micro-cap ETF because micro cap stocks are a distinct asset class from
small caps, with totally different performance. For example, the
Wilshire Micro Cap Index has gained an average of 17% over the last ten
years, versus 11% for the Wilshire Small Cap 1750 index.

Hedge fund managers also need a micro-cap ETF for two reasons.
First, many hedge funds look to small stocks for alpha generating
opportunities, on the assumption that the market for small cap and
micro cap stocks is less efficient and therefore rewards managers with
an information advantage. But small cap and micro cap stocks are hard
to short. This means that many long-short hedge funds suffer from intrinsic market cap bias:
long small and micro caps, short large caps. That net long-bias to
small and micro caps is fine when small and micro-caps outperform large
caps, but is lousy when the reverse is true. The availability of a
liquid micro-cap ETF would solve this problem for many managers, as
they could hedge their long positions in individual micro-cap stocks
with a short position in the micro-cap ETF.

Second, many fund managers use ETFs to play momentum in asset
classes. The more volatile an asset class, the greater the
opportunities (and risks). That's one of the reasons why SMHs
(Semiconductor HOLDRs) are so popular with hedge fund managers: they're
about the most volatile of all the U.S equity ETFs. But now look at the
performance of micro-caps. The Wilshire micro-cap index was up 92% in 2003.
In 2004, it was up another 8.7% in Q1, down 3% in Q2, and down another
5.2% in Q3. Hedge fund managers would love an easy way to access that
volatility.

Links and article tools:
The full Barrons article about MSCI's push into the competitive world of U.S indexing is here
(paid subscription required). It does a good job of outlining MSCI's
methodology and marketing push, but fails to note the dearth of
micro-cap indexes and index funds and why that might be.

By focusing its discussion on large cap indexes and index funds,
Barrons joins the rest of the ETF industry in focusing on asset classes
that are already available to investors, and fails to focus on asset
classes that still lack investable indices. That criticism was one of
points made in Why exchange-traded funds could alter the investment landscape.

For an example of how unintentional market-cap bias hit well-known fund manager John Hussman, look at How hedge fund managers can avoid Hussman’s blow-up.

The ETF Resource Page
is the most comprehensive set of annotated ETF links on the Internet.
It has a section on index providers, including links to Wilshire, MSCI,
Standard & Poors and Russell.

A micro-cap ETF would likely be immediately included in many asset-allocation accounts for retail investors.  A Better Way to Invest discusses asset allocation, rebalancing and tax-loss selling using ETFs.  Does Amerivest compete with hedge funds? You bet! discusses Ameritrade's new asset allocation account using ETFs.

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