After witnessing sluggish growth in the first quarter, the U.S. economy is likely to witness impressive growth conditions as indicated by the recently released economic data. Across all asset classes, small-cap securities are poised to gain from this encouraging scenario due to their significant exposure to domestic economy.

Moreover, low international exposure compared to large- and mid-cap counterparts, make them less vulnerable to sluggish global growth environment. This favorable backdrop led the small-cap index, Russell 2000 (RUT) to gain 6.3% over the past five sessions. Small-cap ETFs that also maintain a diversified portfolio may prove to be profitable in the near term.

Improving U.S. Economy

Recently released domestic economic data including June’s encouraging jobs report, ISM manufacturing and services indexes, and consumer spending data indicated that the U.S. economy is gradually recovering from the first quarter’s sluggish growth conditions. After adding only 11,000 jobs in May, the economy saw healthy volume of 287,000 job additions in June, according to the U.S. Department of Labor. Moreover, the rejoining of 400,000 Americans led the unemployment rate to rise to 4.9% from 4.7% in May (read: ETFs to Buy After Strong Jobs Report).

Additionally, the Institute for Supply Management (ISM) manufacturing index increased from 51.3% in May to a 16-month high of 53.2% in June, above the consensus estimate of 51.3%. Out of 18 manufacturing industries, 12 reported growth leading the ISM Manufacturing index higher. A separate report showed that ISM  Services  Index  advanced  from  52.9%  in May  to  56.5%  in  June,  its  best  rise  in the  last  seven  months. Also, the final services PMI increased from 51.3 in May to 51.4 in June, as per Markit.

Separately, the Federal Reserve reported that consumer credit increased $18.6 billion in May, well above analysts’ expectation of $16 billion. It rose at an annual rate of 6.2%, higher than April’s increase of 4.5%. Also, the Commerce Department reported that consumer spending rose 0.4% in May from April, preceded by a 1.1% rise in April, which was the highest gain in around seven years (read: 4 Consumer Discretionary ETFs to Buy on Increased Spending).

Diversification: A Way to Minimize Risk

Though small-cap securities are expected to gain from this encouraging economic backdrop, investing in these securities may involve higher levels of risk compared to investing in large and mid caps. This is where the concept of diversification comes into play. It is well known that investing in a single or small number of securities is riskier than diversifying one’s asset across a large number of securities (read: Small Cap ETFs Leading Current Market Rally).

This is the reason why a portfolio that efficiently diversifies its allocations across a large number of small-cap securities is best positioned to offer high yield with a lesser level of risk. Moreover, as ETFs maintain a holding of multiple securities, it is prudent to invest in well-diversified small-cap ETFs than in individual securities.

3 Diversified Small-Cap ETFs

With the objective of providing higher return with minimized risks, we have highlighted three well diversified small-cap ETFs that are poised to gain from this favorable scenario. These ETFs also have either a Zacks ETF Rank #1 (Strong Buy) or #2 (Buy) with Medium risk outlook. Also, these saw encouraging returns over the past three months and in the year-to-date frame.

First Trust Small Cap Value AlphaDEX ETF (FYT Quick QuoteFYT - Free Report)

This fund follows the NASDAQ AlphaDEX Small Cap Value Index and holds 262 stocks in its basket with only 0.7% invested in the top firm. It has only 6.7% of its assets allocated in the top 10 holdings. Financials, consumer discretionary and industrials are the top three sectors. FYT charges 70 bps in annual fees while volume is moderate at 34,000 shares a day. The product has managed about $44.9 million in its asset base so far. This Zacks ETF Rank #1 product has gained 5.3% and 10% over the past three months and year-to-date frame.

iShares Russell 2000 Value ETF (IWN Quick QuoteIWN - Free Report)

This follows the performance of the Russell 2000 Value Index. It has a basket of 1,361 stocks that are well spread out across components, with each holding less than or equal to 0.5% of assets. It has only 4.5% of its assets allocated in the top 10 holdings. Financials is the top sector with more than 40% of the portfolio, followed by industrials (12.3%) and consumer discretionary (10.9%). IWN is quite popular with AUM of nearly $5.9 billion and trades in solid volume of more than one million shares per day on average. It charges a higher 25 bps in annual fees. This Zacks ETF Rank #2 fund has gained 7.4% and 10% over the past three months and year-to-date frame (read: Play US Recovery with These Small-Cap Blend ETFs).

Vanguard Small-Cap Value ETF (VBR Quick QuoteVBR - Free Report)

This ETF provides targeted exposure to the domestic small-cap stocks by tracking the CRSP US Small Cap Value Index. Holding 856 stocks in its basket, the fund has only 5% of its assets invested in the top 10 holdings. In terms of industrial exposure, financials makes up the largest share with 30.3%, followed by industrials (20.2%) and consumer services (11.1%). The fund has amassed $7.5 billion in its asset base while trades in impressive volume of 380,000 shares a day on average. VBR is a low choice in the space, charging just 8 bps in annual fees. This Zacks ETF Rank #2 fund has gained 5.6% and 10.3% over the past three months and year-to-date frame.

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