A Multi-Factor Advantage With a Small-Cap Stock | ETF Trends

Small-cap equities are scuffling this year, but investors positioning for a rebound in the asset class should consider a multi-factor approach, such as the one offered by the Principal U.S. Small-Cap Multi-Factor Index ETF (NASDAQ: PSC).

The $250 million PSC, which turns four years old later this year, tracks the Nasdaq US Small Cap Select Leaders Index.

“The index uses a quantitative model designed to identify equity securities (including growth and value stock) of small-capitalization companies in the Nasdaq US Small Cap Index (the ‘parent index’) that exhibit potential for high degrees of sustainable shareholder yield, pricing power, and strong momentum while adjusting for liquidity and quality,” according to Principal.

The value, quality, momentum, size, and volatility factors are among the most well-known equity factors utilized in smart beta ETF strategies. Momentum identifies stocks appreciating in value. Value looks for cheap stocks relative to fundamentals like book yield, earning yield or cash-flow yield, Quality stocks have healthy balance sheets and exhibit steady profitability. Smaller stocks tend to outperform larger stocks over time.

PSC’s Specific Factors

When investing in these various factors, investors may notice that specific factors may outperform over short-term periods since they will act differently in differing market conditions. No single factor dominates or outperforms when looking at extended periods.

Historically, the small cap/value combination has been rewarding, but it took a big hit when value languished during the recently deceased bull market. The tendency of factor leadership to change from year to year underscores PSC’s utility: with the Principal ETF’s multi-factor approach, investors don’t incur the burden of factor timing.

Investors can use a multi-factor strategy such as PSC to capitalize on the cyclicality of factor performance through a dynamic overlay that screens for leading economic indicators and market sentiment to gauge the current market environment and increase exposure to the areas that tend to fare best in the given conditions.

These types of factor-based investments help investors steer away from the potential risks associated with a traditional market-cap weighted fund that can grow top heavy, especially in a prolonged bullish environment.

PSC also significantly reduces the single stock risk. Home to 464 stocks, the fund caps component weights at 0.70% upon rebalancing. The average market value of those holdings is $1.55 billion.

Financial services, healthcare, industrial and technology stocks combine for nearly two-thirds of PSC’s roster.

For more on multi-factor strategies, visit our Multi-Factor Channel.

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.