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Fiscal 2012 has not been particularly smooth sailing for investors. The year was a very eventful one to say the least with a series of sovereign rating downgrades as well as monetary stimulus from central banks across the board.

Nevertheless, as the age old saying goes ‘all’s well that ends well’ , as the stock markets have ended the time period on a positive note with the S&P 500 adding double digits and at least partially making up for a flat 2011.  

As we close the books on 2012, investors will have their focus on the year-end tax liability. Given this, a look at an investment strategy is prudent as it enables investors to profit from a broader market sentiment in the first month of the New Year itself (read Which ETF Should You Buy This Holiday Season?).

This is popularly known as the ‘January Effect.’

The basic idea of this strategy is that investors sell off their losing position trades thereby incurring losses in these trades in December of the previous year in order to set off these losses against the profits made on other trades throughout the year. This is done as a means to reduce the capital gains tax liability.

This idea is popularly known as ‘tax loss harvesting.’ However, in January of the next year the buying begins yet again thereby pushing the equity markets higher in the first month of the new fiscal year.

Several academic researches such as the one by Professor Hakan Altin in the research paper “Stock Exchanges and January Effects” in the International Research Journal of Finance and Economics - Issue 85 (2012), explains this phenomenon. The paper studies the magnitude of the January Effect across various developed as well as emerging markets.

However, its starts with the premise that small cap stocks are more impacted by this phenomenon. Furthermore, the same has been explained by investopedia, that this effect is more prominent in small cap stocks rather than mid and large cap stocks which often need more in buying to move the needle then their small cap counterparts (read Try Small Cap ETFs to Gain from Chinese Domestic Demand).

For investors who seek to capitalize on the opportunity of the January effect in a basket form, the following small cap U.S ETFs could be solid pure play choices to play the idea if it materializes in 2013:

iShares Russell 2000 ETF (IWM - ETF report) is by far one of the largest and most popular ETFs available in the U.S. small cap space. It has total assets worth $15.66 billion and on average around 40 million shares exchange hands each day. IWM tracks the Russell 2000 index which measures the performance of 2000 small cap stocks from the entire universe of publicly traded U.S. stocks.

The ETF charges an expense ratio of 23 basis points and pays out 1.61% as yield. The ETF has returned 13.15% for a one year period as of 30th November 2012. IWM currently has a Zacks Rank of 3 or ‘Hold’ with a ‘Low’ risk outlook (see more in the Zacks ETF Center).

Vanguard Small Cap ETF (VB - ETF report) was launched in January of 2004 and since then has managed to amass an asset base of around $4.5 billion. The ETF tracks the MSCI US Small Cap 1750 Index which measures the performance of the small cap stocks from the U.S. equity space.

The ETF comprises of a very well diversified portfolio of 1,777 stocks allocating just 2% of its total assets to the top 10 holdings. It allocates maximum to aggressive sectors such as Financials (23.10%) and Information Technology (16.70%). It also charges a low expense ratio of 0.16% to investors and pays out 1.20% as an annual yield.

The ETF has an average daily volume of around 253,000 shares and has returned around 15% for the one year period as of 30th November 2012. VB currently has a Zacks Rank of 3 or ‘Hold’ with a ‘Low’ risk outlook (read Time to Invest in Low Volatility ETFs?).

Although the Schwab U.S. Small Cap ETF (SCHA - ETF report) is a relatively new ETF, nevertheless it can be another interesting choice for investors from the U.S small cap equity space to play the January effect. The ETF has been able to amass an asset base of around $735.60 million since its inception in November 2009.

SCHA tracks the float adjusted market capitalization weighted Dow Jones U.S. Small-Cap Total Stock Market Total Return Index. The ETF is composed of 1,746 U.S. small cap stocks.

The best part about the ETF is its paltry expense ratio of 10 basis points making it one of the lowest priced products from this space. It places its bets heavily across aggressive sectors like Financials, Industrials and Information Technology.

SCHA pays out a yield of 1.21% and has returned around 15% for the one year period as of 30th November 2012. The fund currently has a Zacks Rank of 2 or ‘Buy’ with a ‘Medium’ risk outlook.

Risks and Drawbacks

While it is true that past data does show that stocks tend to get a boost in the first month of the year, things have been a bit different this year. Political issues have plagued December markets, while there has been a tinge of optimism as well.

If anything, there has been a decent performance for small caps in December, bucking the trend that many had seen in years past with multiple percentage points gains on the table for the time period in question (read Gold ETFs: Is the Sell-Off Overdone?).

This is not that surprising as the sell off this year has already happened post the presidential election in mid November over fiscal cliff issues and the markets now are more in a consolidation mode.

Political issues could also impact the space now that we are in 2013 as well, as it still remains uncertain how the economy will react to the deal beyond the early positive results. This could be especially true if the debt ceiling debate becomes intense, as this could throw another wrench into the January Effect, although we look for this fight to begin in earnest once the calendar changes to February.

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