ETF Trends
ETF Trends

When picking out small-capitalization stock exposure, exchange traded fund investors may be better of with funds based on alternative indices that weed out weaker companies.

For instance, small-cap ETFs like the WisdomTree SmallCap Dividend Fund (NYSEArca: DES), PowerShares Fundamental Pure Small Cap Core Portfolio (NYSEArca: PXSC) and First Trust Small Cap Core AlphaDEX Fund (NYSEArca: FYX) track alternative or smart-beta indices that don’t follow traditional market-capitalization weighted methodologies, as opposed to the widely monitored iShares Russell 2000 ETF (NYSEArca: IWM), which is based of the Russell 2000 benchmark. [A Small-Cap ETF With an Advantage]

According to a recent research note, “Size matters, if You Control Your Junk,” conducted by US hedge fund AQR, along with Tobias Moskowitz, a finance professor at Chicago Booth, small-cap stocks outperform large-caps when quality of the companies is taken into account, reports James Mackintosh for Financial Times.

Controlling for quality/junk also explains interactions between size and other return characteristics such as value and momentum,” according to the research paper.

Many small-cap stock investors have been disappointed by last year’s nine percentage point underperformance to large-cap stocks. However, the research paper explains that investors should compare like with like. For instance, small high-quality companies outperformed larger high-quality companies, while small junk beat out large junk stocks.

Consequently, funds and ETFs based off benchmark indices like the Russell 2000 or the FTSE Small Cap, which carry more junky stocks at the bottom end of the market, would offset potential benefits of quality small-cap stocks.

However, when controlling for quality, small-caps have generated decent returns. For example, DES weights holdings based on the aggregate cash dividends that companies are projected to pay in the coming year. PXSC is based on a RAFI Fundamental Index, which selects components based on fundamental factors like sales, cash flow, dividends and book value. FYX ranks stocks from the S&P SmallCap 600 Index on growth factors including three, six and 12-month price appreciation, sales to price and one year sales growth, and separately on value factors including book value to price, cash flow to price and return on assets. [Indexes Make a Difference With Small-Cap ETFs]

Over the past year, DES has increased 7.3% and PXSC gained 8.4%. In contrast, IWM rose 2.8% over the past year.

Nevertheless, over the short-term, “beta<” or sensitivity to broad market moves, will be more important that risk-adjusted returns, and small-caps will do relatively well in a rising market conditions, especially over the first months of the year when the lowest quality stocks typically outperform, according to Moskowitz.

For more information on small-capitalization stocks, visit our small-cap category.

Max Chen contributed this article. Tom Lydon’s clients own shares of IWM.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.