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Forget SPY, Focus on Mid and Small Cap ETFs

IJH SPY IWM

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Improving consumer confidence and a continued rise in the employment rate gave the U.S. a good start to the year, sending all indexes to near all time highs.  The S&P 500 index crossed its $1500 level and is up over 3% year-to-date (read: 3 Ways to Play the S&P 500 Rally with ETFs).

While large caps have taken the lion’s share of attention, mid and small caps could arguably be better plays in today’s environment, as they are safer and could be better positioned if more political issues creep into the picture.

This is especially true as investors have pulled out billions from popular large-cap focused funds, such as (SPY - ETF report), and put the capital into other corners of the market instead, such as the following ETFs:

Mid Cap ETF in Focus

Mid caps are considered too big and safe for those seeking volatile small cap exposures, while they are often considered too risky and uncertain for those who want the stability of mega caps.

Still, thanks to investor confidence and huge inflows into these securities, mid cap ETFs have been soaring higher and leading the market in 2013. These ETFs are often less popular than their small or large cap cousins which have managed to establish a stronger asset base.

The mid-cap space has been a solid performer over the long term. Also, these funds are outperforming both their small and large cap counterparts when looking at both the year-to-date and five-year time frames (read: Mid Cap ETFs Leading the Market in 2013).

Keeping this trend in mind, we have highlighted the largest and the most popular mid-cap blend fund- iShares Core S&P Mid-Cap ETF (IJH), which have seen solid gains this year, far in excess of the large and small cap counterparts.

Launched in May 2000, the product has seen solid fund inflows this year with total assets of over $15.6 billion under management. It is the low cost choice in the mid-cap space, charging just 15 bps in fees per year from investors (see more ETFs in the Zacks ETF Center)

The fund seeks to replicate the price and performance of the S&P MidCap 400 Index, before fees and expenses, holding 401 stocks. It is well spread out as it puts less than 8% of its assets in the top ten holdings. Regeneron Pharmaceuticals (REGN), Hollyfrontier (HFC) and Equinix (EQIX) occupy the top three positions in the basket.

However, the product is heavy on financials and industrials, which together make up for 40% of total assets. It is heavily traded in average daily volumes of nearly 200,000 shares, probably ensuring no additional cost for this popular product. The ETF has returned about 4% so far in 2013, easily beating out large cap competitors.

Further, the fund yields a decent dividend of 1.31% per annum. Investors might consider this fund as a nice momentum play as we go further into 2013 (read: Three Surging ETFs with Strong Momentum). Currently, IJH has a Zacks ETF Rank #1 or ‘Strong Buy’ rating. This suggests that this product is expected to perform well over the long haul, when compared to the other funds in the mid cap space.

Small Cap ETF in Focus

Small caps are usually better than the large cap counterparts for those seeking more domestic exposure. These funds allow the investor to tap the domestic population of the economy and usually offer a more spread out exposure.

While small caps are often capable of higher levels of growth than large caps, these can experience levels of volatility as huge gains and losses can occur in a very short period of time (read: Try Small Cap ETFs to Gain from Chinese Domestic Demand).

With this backdrop, the largest and the most popular small cap ETF - iShares Russell 2000 Index Fund (IWM) - has attracted huge inflows of over $1.4 billion, making it the most successful product this year. With AUM of $19.2 billion, the ETF tracks the Russell 2000 Index, which is a capitalization weighted 2,000-stock subset of the Russell 3000 Index.

The product holds about 1,972 securities and is widely diversified as it puts less than 3% in the top ten holdings. Ocwen Financial (OCL), Axiall (AXLL) and Pharmacyclics (PCYC) are the top three elements in the basket. However, the product is tilted towards financial and consumer discretionary (read: 5 Sector ETFs Surging to Start 2013).

The fund offers extreme liquidity, trading in volumes of more than 37 million shares a day. This suggests that no additional cost is involved in the form of bid/ask spread beyond the expense ratio of 0.25%. IWM generated good returns of 3% this year, although it has exhibited significant volatility in the past few weeks.

Investors should note that the returns for this product is less than the mid-cap counterpart, as depicted by IJH, but higher than the large cap SPY by 100 bps. Additionally, the ETF pays an annual dividend yield of 1.86%, which isn’t too bad considering the growth focus of the fund. IWM has a Zacks ETF Rank #3 or ‘Hold’ rating.

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