ETF Trends
ETF Trends

With the various market segments beginning to show diverging growth and small capitalization stocks gaining on their large-cap counterparts, exchange traded fund investors may consider an actively managed small-cap option to capitalize on potential opportunities ahead.

On the recent webcast Tuesday, Active & Passive in a Simple Small-Cap ETF Discipline, Michael Simon, Founder, President and Chief Investment Officer of AlphaMark, pointed out that the small-cap Russell 2000 index has largely underperformed their large-cap peers and the S&P 500 index. Since small-caps have historically outperformed large-cap stocks over the long-term, the recent underperformance over the past five years leaves smaller company stocks open to mean reversion.

Small-caps may also perform in a rising rate environment. Simon pointed out that in two of the three past rate hike cycles, small-caps outperformed large-caps in the following 36 months. In previous periods, large-caps typically ran up and valuations grew pricey, which pushed investors toward more attractive opportunities in small-caps.

“One could argue that today’s environment is similar based upon the increases we saw in the most liquid and largest companies in the S&P 500 over the last couple of years,” Simon said.

Investors interested in a disciplined, actively managed small-cap strategy can take a look at the AlphaMark Actively Managed Small Cap ETF (NasdaqGM: SMCP). SMCP’s strategy follows a bottom up approach with a focus on sector diversification, includes high quality and high conviction picks, identifies components based on earnings momentum, narrows picks based on a company’s conservative cash flows, follows a strict sell discipline, is always fully invested and combines momentum and conservative cash flow valuations.

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The active small-cap ETF focuses on companies with a market-cap of between $150 million and $2 billion. While the main focus of the ETF is U.S. small-caps, SMCP can also hold up to 30% of net assets in foreign small-cap equity securities traded on a U.S. exchange as ADRs.

Currently, SMCP includes about a 90.4% weight in North American equities, along with 2.6% in emerging Africa/Middle East and 7.0% emerging Asia.

“AlphaMark Advisors incorporates a proprietary three-tier cash flow model to identify those companies that we believe can produce reliable cash flow streams and are priced at a level that justifies the growth opportunity,” Simon said.

For example, the small-cap equity selection process starts with companies showing a 20% or greater intrinsic undervaluation, which is then broken down based on price-to-earnings, price-to-book, price-to-sales on operating margin and EV/EBITDA.

Additionally, the small-cap strategy implements a number of factors to achieve a type of active, passive strategy. Once SMCP has achieved alpha, the strategy may revert back to the Russell 2000. If the portfolio outperforms the benchmark index by 5%, the portfolio will go back to its starting universe of Russell 2000 stocks. Then a phantom portfolio will be created from the ETF’s positions and managed the same way as a live portfolio, including buys and sells. Because SMCP is a concentrated fund with high beta stocks, invariably the phantom portfolio’s outperformance will revert to the mean. At this point the Russell 2000 Index inside of SMCP will be sold and the phantom portfolio will be bought back into SMCP thereby creating another alpha-generating opportunity.

“If we try to capture these time periods of excess positive volatility and attempt to reinvest in these periods of mean reversion, while staying fully invested in the benchmark, while waiting for the mean reversion, the potential result could be accumulated excess returns over the benchmark,” Simon added.

Financial advisors who are interested in learning more about small-cap weighted strategies can watch the webcast here on demand.