Fellow InvestorPlace contributor Dan Burrows recently had an interesting look at the market’s current returns. Dan noted that, as the market has pulled back from its peaks, blue-chip large-cap stocks — as represented by Dow Jones Industrial Average — have held up better than small- and mid-cap firms.
This is to be expected, as the riskier the stock, the farther it will rise or fall in bull or bear markets, respectively.
What’s interesting, though, was that the smallest of the small — microcaps and nanocaps — have actually held up better than their less-risky twins. While this can be viewed as outliers, it also goes to show that adding a dose of these tiny companies can help portfolio returns.
Dan, however, suggests that investors shouldn’t go “plowing your nest egg into microcaps or nanos” as they are “hardly a sound bet or a place for anything but a smidgen of your vanity portfolio.”
I do agree with Dan’s assessment that you shouldn’t be buying individual penny or pink-sheet stocks with your retirement money. Nonetheless, not all of the “smallest of the small” are scams. There are opportunities in the space — if you think and act broadly.
Fit for Funds
Micro-cap stocks are often overlooked by investors and can provide a “happy hunting ground” for portfolio returns. Research by famed economists Fama & French, for example, shows that companies with market caps of less than $250 million outperform their slightly larger twins by a wide margin over the longer term.
One reason is that such small firms are perfect for finding various inefficiencies with market share pricing. To start, there is little to no analyst coverage of these companies. For example, there are at least 21 different brokerage firms that cover tech giant IBM (NYSE:IBM). There are only two that cover gold-miner Claude Resources (NYSE:CGR), on the other hand.
On top of that, institutional investors often lack interest in the sector because the names are simply too small to make a meaningful impact on a portfolio of immense size. Additionally, stocks in the micro-cap sphere often lack “institutional sized” liquidity — meaning millions of shares traded each day — and may have wide bid/ask spreads. There’s a reason why investors and analysts sometimes call them lottery stocks.
Still, these picks don’t have to be like lottery tickets. Despite their shortcomings, there are plenty of micro-cap stocks with strong business and financial strength. Investors perceiving the sector as super-risky could be missing out on the extra boost microcaps can provide. Curbing that risk comes courtesy of the boom in exchange-traded funds.
There are now several funds that track the various micro-cap indices. Like Dan, I wouldn’t recommend going whole-hog into these funds. But shifting a portion of your general small-cap allocation into one of these vehicles — say 5% to 10% — could do your portfolio a world of good. With that in mind, here are the top three funds tracking the sector.
Funds Fit for You
1. iShares Russell Microcap ETF: The gold-standard index tracking this sector is the Russell Microcap, which makes the iShares Russell Microcap ETF (NYSE:IWC) the gold-standard ETF. The fund’s 1,320 holdings include some household names like Popeye’s Chicken parent company AFC Enterprises (NASDAQ:AFCE) and trailer manufacturer Wabash National Corp. (NYSE:WNC). As such, the ETF pays a nearly 2% dividend and has returned around 12% annually over the last three years — all for a relatively cheap 0.69% in expenses.
2. PowerShares Zacks Micro Cap Portfolio: Want a more concentrated bet? Try the PowerShares Zacks Micro Cap Portfolio (NYSE:PZI). The fund tracks investment research group Zack’s Micro Cap Index, which is designed to identify a group of micro-cap stocks with the greatest potential to outperform passive benchmark micro-cap indexes and other actively managed U.S. micro-cap strategies. This results in a more concentrated portfolio of 398 names.
Over the last three months, PZI is nearly 11% higher, compared to the 6% rise in the S&P 500 over the same period. However, over the longer term, PZI has managed to underperform IWC by several percentage points. On the brightside, the PowerShares Fund does currently have a distribution yield of 3.8% … but there have been times that PZI hasn’t made any quarterly payouts at all. Furthermore, when it does make a dividend payment, they have fluctuated rapidly. Some of that has to do with how quickly the underlying index churns through holdings in order to meet its mandate of “beating the passive microcap indexes.” As such, investors shouldn’t count on PZI as major or steady source of income in their portfolios. Expenses run at 0.91%
3. Guggenheim Wilshire Micro-Cap ETF: In terms of holdings, the Guggenheim Wilshire Micro-Cap ETF (NASDAQ:WMCR) is right in the middle of the list with 866 different stocks. The fund tracks the Wilshire Micro-Cap Index, which represents the bottom 1,500 firms in the broad Wilshire 5000 index. WMCR does a great job of spreading out assets, as no one stock accounts for more than 1% of the fund. Conversely, WMCR is somewhat top-heavy from a sector perspective. Financials, healthcare and technology combine to make up around 60% of assets, though, which could make the fund extra-volatile if the market seas get rocky. Still, one huge positive for the Guggenheim ETF is that its the cheapest of the bunch at just 0.58%.
The bottom line is that investor’s should be afraid of micro-cap space. They just to need to play it smartly … by thinking broadly.
As of this writing, Aaron Levitt was long IWC.