How to Take Some of the Risk Out of Small-Cap Investing

In equity investing, there’s no such thing as a free lunch, and that’s particularly true when it comes to small-cap stocks. That asset class is popular with market participants due in part to strong growth prospects, and with that comes the possibility of elevated risk and volatility.

That’s simply the price of admission for the small-cap space, but there are avenues for trimming some of that risk. Consider the Invesco NASDAQ Future Gen 200 ETF (QQQS). The Invesco exchange traded fund has spent a significant portion of 2023 outperforming traditional small-cap rivals, indicating that while it’s not perfect, QQQS possess some advantages over old guard smaller-stock ETFs.

The perks offered by QQQS are meaningful at a time when market participants are fretting about the potential arrival of a recession. That outlook has been one of the primary drags on small-cap stocks and ETFs this year. Conversely, smaller stocks often lead when coming out of economic malaises.

“The relative size and competitive positioning of small-cap companies allow them to quickly capitalize on new business opportunities,” noted Morningstar analyst Zachary Evens. “These opportunities may be risky but can lead to big payoffs for companies that execute effectively. Investors are willing to pay up for companies like these during bull markets, driving their share prices higher. Because of this, small-cap stocks in aggregate can perform especially well when markets rise.”

Assessing QQQS Perks

As Evens points out, there’s a dearth of small-cap names with the wide moat designation.

“Smaller companies are risky because they don’t usually possess the same meaningful competitive advantages as larger firms. Only 1% of companies in the Morningstar US Small Cap Index boast a wide Morningstar Economic Moat Rating, compared with 67% of constituents in the Morningstar US Large Cap Index,” observed the analyst.

Specific to QQQS, while many of the fund’s 203 holdings don’t meet the strictest definition of “wide moat,” they operate in spaces that are difficult to enter, including emerging corners of biotech and other innovative technologies. That’s a relevant trait for multiple reasons.

First, it suggests that QQQS member firms have some built-in competitive advantages. Second, it’s possible that those perks could make some QQQS components appealing to prospective buyers. At the end of the day, there’s no such thing as “perfect” when it comes to small-cap ETFs, but QQQS does have positive attributes to consider.

“Not all index ETFs are created equal, though. ETFs tracking small-cap indexes that effectively control for the unique risks of that market should give investors the best chance for outperformance over a full market cycle,” concluded Evens.

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