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Time to Focus on Small Cap ETFs?

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Although volatility levels have increased, the U.S. market continues to climb upward this year thanks to growing investor confidence, improving employment data and a recovering economy. The S&P 500 index remains above the 1,600 level and is up over 10% year-to-date.

While large caps have taken the lion’s share of attention, small caps could arguably be better plays in today’s economy, as these are safer and could be better positioned if more political issues creep into the picture (read: Is This a Better Large Cap ETF?).

Why Small Caps?

The confidence in the international economy is fading, underscoring the tough challenges to emerge out of recession. Many emerging markets, including China, are also experiencing slowdown. However, the U.S. economy is on the verge of recovery with encouraging housing data and lower jobless claims data (read: Are China ETFs in Trouble?).

In such a scenario, a purely large cap focus doesn’t seem like a great strategy as most large and mega cap securities do a significant amount of business outside of the U.S., implying that the exposure to large caps isn’t likely to be too focused on American economic health. In fact, the S&P 500 companies collectively make nearly one-third of their revenues from the international markets.

That is why, in our opinion, true domestic exposure can best be achieved via small cap securities. These pint sized stocks aren’t big enough to be international behemoths, so they are pretty much entirely focused on the U.S. for their revenues, potentially making them great choices in a global slowdown. To substantiate this fact, the small cap index – represented by the Russell 2000 – generates less than 20% of revenue outside the U.S.

This makes these securities perfect for the present, when the American economy is arguably leading the way. Furthermore, since these companies are small, they have a much easier time growing than their already tapped out large cap counterparts (read: Forget SPY, Focus on Mid and Small Cap ETFs).

This trend is expected to continue this year, especially if emerging markets stay weak and Europe continues to fight debt issues, according to the analysts at Goldman Sachs (GS). The analysts expect that the Russell 2000 Index will generate 14% returns over the next 12 months compared to a modest 6% gain for the S&P 500 index. The Russell 2000 Index is up roughly 14% so far this year.

Small Cap ETF in Focus

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. In this backdrop, we have highlighted three popular unleveraged small cap ETFs, which could be great choices for investors seeking higher income in the second half of the year (see more ETFs in the Zacks ETF Center):

iShares Russell 2000 Index Fund (IWM)

Launched in May 2000, this is by far the largest and the most popular ETF in the small cap space. The ETF tracks the Russell 2000 Index, a capitalization weighted 200-stock subset of the Russell 3000 Index.

Holding roughly 2,000 securities, the fund eliminates specific company risk as it puts just a fraction in each security. None of the individual securities holds more than 0.34% share. Alaska Air Group (ALK), Starwood Property (STWD) and Ocwen Financial (OCN) are the top three elements in the basket.

However, the product is tilted towards financial services and consumer discretionary sectors, which together make up for 40% of the total assets (read: Banking ETFs: Laggards or Leaders?).

IWM has attracted huge inflows this year, suggesting that investors are embracing a small cap approach. This has propelled the fund’s asset base to roughly $21 billion. Though not a low cost choice in the small cap space, the product does not involve any extra cost in the form of bid/ask spread beyond the expense ratio of 0.25%. This is because it offers extreme liquidity, trading in volumes of more than 38 million shares a day.

The ETF gained 14.84% in the year-to-date period and yields a decent 1.50% in annual dividends. The product has a Zacks ETF Rank of #3 or Hold with a low risk outlook.

iShares Core S&P Small-Cap ETF (IJR)

This fund has attracted $875 million in asset base, accumulating over $10.1 billion in total assets by tracking the S&P SmallCap 600 Index.

Like IWM, the product is well diversified across each security as none of them holds more than 0.60% of the assets. Tanger Factory Outlet Center (SKT), Gulfport Energy (GPOR) and Cymer Inc (CYMI) hold the top three positions in the basket.

The fund is also spread well across variety of sectors. The top sector – financial – accounts for roughly one-fifth share, closely followed by information technology, consumer discretionary, industrials and healthcare.

Launched in May 2000, the fund charges low fee of 0.16% on annual basis. Additionally, it trades in daily volume of roughly 900,000 shares, probably ensuring no additional cost. The ETF returned 15.31% so far in the year and pays a good annual dividend of 1.20%.

IJR currently has a Zacks ETF Rank of #1 or Strong Buy with low risk outlook. This suggests that the product would outperform its counterpart over a one-year period.

Vanguard Small Cap Fund (VB)

This fund tracks the CRSP US Small Cap Index and holds 1,440 stocks in its basket. It has seen inflows of over $700 million, sending AUM to about $6.2 billion.

The product puts little (not more than 0.3%) in each security that could keep the portfolio balanced among the various companies, and prevent a heavy concentration. The top three holdings include Rock Tenn (RKT), Onyx Pharma (ONXX) and B/E Aerospace (BEAV).

From a sector perspective, financials again take the top spot in the basket with one-fourth of VB while industrials (16.10%), consumer discretionary (14.90%), information technology (14.70%) and healthcare (10.70%) rounded off the top five (read: Two Sector ETFs Posting Incredible Gains).

The ETF, launched in Jan 2004, is the low cost choice in the space, charging only 10 bps in fees a year from investors. But, its moderate daily volume of roughly 350,000 shares slightly increases the total cost for this popular fund. The fund is up 16.55% year-to-date and pays decent dividend of 1.59% per annum.

VB has a Zacks ETF Rank of #2 or Buy with low risk outlook.

Bottom Line

Small caps have been surging higher as of late, and are considered by many to be the new leaders of the market.

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