The small-cap sector has been underperforming for a while, but recently chart watchers, as well as long-term buyers and holders, have been delighted with the performance of small-cap stocks. Mid-cap stocks have also enjoyed success lately. These two cap-sizes have long performed in unison. They are more volatile than large-cap stocks, and can be riskier, but when they move, they move. Now, in a low-interest environment — and one that might have another huge injection of funds into the economy from the Federal Government — small- and mid-caps could handsomely outperform. That’s why I’d like to bring your attention to several standout index funds related to this theme.
But first, let’s take a closer look at why small- and mid-cap stocks should be on your radar today.
Over the last five years, the iShares Core S&P Small-Cap ETF (NYSEARCA:IJR), the exchange-traded fund that is structured to replicate the iShares Core S&P Small-Cap index fund, has lagged in performance below the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), its large-cap companion. However, it has caught up recently. IJR also underperformed the SPY on a two-year basis, but outperformed SPY in the latest one-year period. And in almost any measurement of anything less than a year, IJR has handily beaten SPY.
The charts, and the fundamental data, suggest that this trend will continue.
Small-caps, because they are smaller companies with more upside growth potential, usually sell at higher price-to-earnings-to-growth (PEG) ratios than large-cap companies. But that’s not always the case. For example, the PEG ratio of SPY, is 2.44x; meanwhile, the PEG ratio of IJR is 1.36x, a much lower valuation.
I would rather buy promising small companies that are in an economic environment that could receive further government stimulus, than big companies with those same characteristics. And, at this time, they can be bought at a lower valuation.
Here are three index funds that replicate ETFs that could outperform on a near-term basis and over a longer-term period:
- Invesco S&P Small-Cap Information Technology ETF (NASDAQ:PSCT)
- Invesco Nasdaq NextGen 100 ETF (NASDAQ:QQQJ)
- First Trust Financials AlphaDEX Fund ETF (NYSEARCA:FXO)
Index Funds: Invesco S&P Small-Cap Information Technology ETF (PSCT)
PSCT enjoys placement at the sweet spot of market performance: technology and small cap. This is a solid reason why many might consider it a buy. Likewise, the reason to hold PSCT is that tech is and could continue to be a growth area. If the sector continues to run hot, small companies could perform better on a growth basis than the bigger companies because their sales base is lower, and their growth from that base could be easier to attain. In other words, it’s much easier for a smaller company to double its earnings than a large company to do the same thing.
I think tech will continue to be a good growth sector, although there could be leveling out periods where tech will not outperform. But the upsides should more than make up for the times when growth might be average or underperforming, especially in the small-cap tech space.
PSCT is based on the S&P SmallCap 600 Index Fund and chooses those companies in the index that are engaged in U. S. information technology. The ETF is capitalization weighted. This weighting allows the index to have more exposure to bigger companies than other capitalization models.
The PSCT Price/Earnings to Growth (PEG) ratio is about 2.63x. That’s high, but not unusual for small-cap tech, which usually sells at a high valuation that often exceeds tech-based large-cap index funds. However, PSCT proves to be an exception to this. The Technology Select Sector SPDR Fund (NYSEARCA:XLK) replicates a big-cap index fund in tech. And XLK is selling at a 2.63x ratio, which is the same ratio as PSCT.
PSCT gives holders the opportunity to hold companies that operate in the dynamic niches of the tech industry. For example, its largest holding is Power Integrations (NASDAQ:POWI), which develops and distributes worldwide integrated circuits and other electronics used in high-voltage conversions.
Invesco Nasdaq NextGen 100 ETF (QQQJ)
The weighting of the index fund that is replicated by the Invesco QQQ Trust (NASDAQ:QQQ) ETF is simple: it contains the 100 largest domestic and international non-financial companies that are listed on the Nasdaq. The biggest companies are included: That seems almost too simple, yet this weighting has worked out very well. The index is modified cap-weighted, so, although the bigger the company, the heavier weight of that company will be in the index, the index still limits the size of any one company’s inclusion in the index.
QQQ has outperformed the S&P 500 handily in most up-market timeframes. Conversely, QQQ has gone down more than the S&P in most down-market timeframes. But the down-market performances of QQQ started from a higher base than the price of SPY, resulting in a comparative better performance for QQQ.
That all takes us to the QQQJ. Invesco has taken this popular and successful weighting method and come out with a new ETF that borrows from the formulas used in creating QQQ. The QQQJ replicates the Invesco Next Generation 100 Index, and invests in a universe of smaller companies, which are the 101st to 200 largest companies on the Nasdaq. This results in a small- to mid-cap index of Nasdaq-listed, non-financial companies. Because of the growth-oriented index fund methodology, QQQJ primarily holds growth sector companies. As such, companies in the healthcare and technology sectors are its largest sector representation.
The largest company holding in QQQJ is CrowdStrike (NASDAQ:CRWD). CrowdStrike offers cloud-delivered solutions for endpoint protection in companies around the world. Another top holding in QQQJ is Roku (NASDAQ:ROKU). Roku, with its subsidiaries, operates a TV streaming platform. The platform enables users to access movies, TV episodes, news, sports and other viewing outlets.
First Trust Financials AlphaDEX Fund ETF (FXO)
It’s often profitable to buy into a sector that has been out of favor for a long time if it has a good chance to come back into favor. That’s especially true if it’s reason for coming back into favor is because the fundamentals have swung or are swinging back its way. This could very well be the way with two downtrodden sectors: energy and financials.
The financial sector has been improving for a while now, and further improvements could be coming. It is a matter of time until interest rates reverse themselves, and it is a good bet that the time should be close.
A good way for the federal government to get its fiscal house in order is for it to foster, encourage and promote inflation. The government likes to pay back debt with cheaper dollars. And inflation allow this. Inflation could drive up interest rates, and banks, insurance companies and other financial institutions would benefit.
It’s just about time this happens: There has been a bond bear market for about forty years; that is a long enough time for that market to start reversing.
In this environment, a promising buy in this sector is the First Trust Financials AlphaDEX Fund ETF. The AlphaDex methodology is used by First Trust Investors to make the selections that go into its index funds. FXO holds banks, non-life insurance companies, investment banking, brokerage service companies and other financial companies.
Some of its notable holdings include names like First Citizens BancShares (NASDAQ:FCNCA). FCNCA operates as the holding company for First-Citizens Bank & Trust Company. The bank provides retail and commercial banking services to individuals, businesses and professionals, in many states. Likewise, another FXO holding, Sterling Bancorp (NYSE:STL) is the bank holding company for Sterling National Bank. It provides banking products and services to commercial, consumer and municipal clients in the United States. The final holding I’d like to point out, Popular (NASDAQ:BPOP), provides various retail, mortgage and commercial banking products and services through its subsidiaries. The company creates various deposit products.
Max Isaacman is a Registered Investment Advisor in San Francisco. His investment books were published by McGraw-Hill and Financial Times Press, including the first book on ETFs, How to be an Index Investor (McGraw-Hill, 2000), and the first book on understanding the Nasdaq Market, The Nasdaq Investor (2001). He wrote for the Emmy award-winning Website Minyanville.com. His email is email@example.com.
He, and some of his clients, own PSCT, QQQJ and FXO.