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Tapping the Action in Microcaps

By Richard Diennor Until recently, investors who wanted to own shares of the smallest U.S. companies through exchange-traded funds had no options. Now three ETFs focus on very small stocks.

The new offerings -- iShares Russell Microcap Index Fund (IWC), First Trust Dow Jones Select MicroCap Fund (FDM), and PowerShares ETF-Zacks MicroCap Fund (PZI) -- differ in their investment approaches and holdings.

LIQUIDITY, PLEASE. The $71 million iShares ETF introduced by Barclays Global Investors tries to match as closely as possible the performance of its benchmark, the Russell Microcap index. The fund's bogey contains about 2,000 stocks, but Barclays narrows that down to about 1,200, seeking those that are the most representative of the index and that can be traded most easily without significantly affecting their prices.

"The focus here is on liquidity," says Patrick O'Connor, a senior portfolio manager at Barclays who heads the team that oversees the ETF. A company's financial fundamentals are not a consideration for gaining entry into the fund, he says.

That's not the case with First Trust's ETF. Companies judged to be in poor health are excluded from the $35 million fund, which holds about 300 stocks. It looks at factors such as profit margins, stock valuations, and total returns.

LOWER EXPENSES. The $87 million PowerShares fund, which owns around 330 stocks, also operates more actively. Like other ETFs offered by the company, Zacks Microcap tracks an index composed of stocks seen as having the greatest potential to outperform a passive benchmark as well as actively managed funds.

Sectors favored by the three funds can also vary. Information-technology companies account for about 22% of the PowerShares fund's portfolio. The iShares fund has roughly the same percentage in financial-services companies. (Sector holdings for the First Trust fund were not immediately available.)

The funds do, however, have the same expense ratio: 0.60%. That's much lower than the 1.87% expense ratio sported by the average microcap mutual fund.

SEIZING THE MOMENT. When the ETFs debuted in September, fund industry observers said the three companies were trying to take advantage of investors' thirst for small-cap stocks, which they noted have performed better than large caps over the last few years. Microcap stocks are generally defined as those of companies with market capitalizations of $350 million or less.

Shauna Ginsberg, a research analyst with fund tracker Financial Research, said the companies are also trying to leverage the popularity of ETFs, whose assets have swelled in recent years. Unlike mutual funds, ETFs trade throughout the day and can be sold short.

Microcap funds had cash inflows of $191 million through the end of September this year, FRC said. That followed outflows of $664 million in 2004 and $771 million in 2003.

ESCAPING ATTENTION. Only a handful of mutual funds invest in microcap stocks. There are currently 41 such funds, not including multiple share classes, according to Standard & Poor's data, and many are closed to new investors. Concerns about liquidity frequently lead fund companies to shut small-cap and microcap funds when their asset levels grow too large.

While not as many mutual funds or ETFs invest in microcaps, those that do can reap big rewards, observers note. Microcap mutual funds returned 14.9% on average for the 12-month period through the end of October. By comparison, the S&P 500-stock index, which holds large companies, rose 8.7% during that span.

Small companies can increase sales and earnings much faster than large ones, and that can boost their share prices. They also tend not to be widely followed by brokerage houses, so investors who do their homework on these stocks may be able to cash in. Small stocks also can take off when Wall Street analysts begin tracking and promoting them.

BACK TO LARGE CAPS? However, small- and microcap stocks can also be highly volatile, so they can fall as quickly and as far as they rise, observers point out. Because of their potential volatility, investors should limit their investments in microcap stocks to about 5% of their portfolios, advises Rosanne Pane, mutual-fund strategist at Standard & Poor's.

Market watchers at Standard & Poor's have said in recent months that they expect investors to begin returning to large-cap stocks at some point in 2006 if interest rates and inflation increase and the U.S. economy cools. "Smaller companies have outperformed over the last few years, and the larger-cap companies have underperformed," says Alec Young, an equity-market strategist with S&P. "And we're looking for that to shift as this bull market and the economic cycle age."

Microcap ETFs


October Return (%)

Assets (mil., as of 11/11/05)

Expense Ratio (%)

iShares Russell Microcap Index Fund (IWC)




First Trust Dow Jones Sel MicroCap Fund (FDM)




PowerShares ETF-Zacks MicroCap (PZI)




Diennor is a reporter for Standard & Poor's Fund Advisor

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