This Niche Offers Broad Diversification

03/20/2013 7:45 am EST

Focus: ETFs

Jim Lowell

Partner & Chief Investment Officer, Adviser Investments

Small-cap stocks are undervalued and underfollowed right now, writes Jim Lowell of Forbes ETF Advisor.

Small-cap stocks are defined in various ways. The two most common small-cap benchmark indexes are the Russell 2000 and the S&P Small Cap 600 index.

The Russell 2000 currently has an average market cap of $1.4 billion and a median market cap of $540 million. The S&P 600 Small Cap index defines small-cap stocks as $300 million to $1.4 billion. A market capitalization under $1 billion but more than $150 million is the bandwidth I think of when thinking about global small-cap stocks.

Note that I said “global small-cap stocks.” Many investors and institutions—and, for that matter, the two indexes above—continue to view small-cap stocks through a domestic lens. Bu, as you well know, we think and act more broadly, looking to cross the border from established foreign markets to the established and frontier emerging markets in our quest for companies big and small.

Who should invest in small caps? Small-cap stocks are suitable for any investor with an S&P 500-like risk tolerance and an investment time line that is greater than three years. I say three years, but ideally my investment timeline for any asset class and/or capitalization range is seven to ten years.

Small-cap stocks are increasingly underfollowed and under-analyzed by the brokerage shops, even as they have been consistently pursued by no-load mutual fund companies big and small, and more recently ETFs.

When it comes to small-cap stock investing, I think that mutual fund and ETF investors alike have a distinct advantage over the "buy what you’re sold" approach of the brokerages that may have a “hot” small-cap stock on their shelves that they want to sell you.

The advantages: a broad range of small-cap ETFs that cover the domestic and global grounds increasingly well; diversified, low cost, transparent, and flexibly traded, liquid investments in a space where liquidity can evaporate when you least want it to.
First Trust Dow Jones Select MicroCap (FDM) seeks investment results that correspond to the price and yield performance of the Dow Jones Select Microcap Index. Micro-capitalization stocks are defined as stocks of companies with market caps between $50 and $300 million. Micro-caps fall between nano and small-cap stocks.

The top three sectors are financials (28.7%), industrials (20.1%), and consumer discretionary (15.1%). The top ten holdings are OfficeMax (OMX), Acco Brands (ACCO), Krispy Kreme Doughnuts (KKD), Badger Meter (BADG), Oriental Financial (OFC), Altra (AIMC), Headwaters (HW), Piper Jaffray (PJC), Advanced Energy (AEIC), and Consolidated Communications (CNSL).

iShares Morningstar Small-Cap (JKJ) seeks investment results that correspond to the price and yield performance of the Morningstar Small Core Index, which is made up of small cap stocks chosen by Morningstar’s index methodology.

The top three sectors are industrials (20.9%), consumer cyclical (19%), and technology (13.1%). The top ten holdings are Abercrombic & Fitch (ANF), Alaska Air (ALK), Patterson-Uti Energy (PTEN), JDS Uniphase (JDSU), Teleflex (TFX), Omega Healthcare Investors (OHI), Acuity Brands (AXI), Visteon (VC), Louisiana-Pacific (LPX), and Mid-America Apartment Communities (MAA).

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