Why Investors Shouldn't Overlook Small Cap ETFs

As ETF investors look toward new investment opportunities, they should consider some key developments in the world of smaller stocks.

In the recent webcast, Go Small or Go Home: Why Choose Small Caps in Today’s Market, Ben Jones, Index Development Specialist, Nasdaq, highlighted the rise of small caps, pointing to the rebound off the lows, recent relative strength compared to large caps, attractive valuations, strong fund flows, and diversity in sector exposure as compared to the large cap segment.

Small caps have been gaining momentum, outperforming their large cap counterparts in recent months, as investors look for opportunities outside of high-flying large cap growth names. Even with the recent outperformance, Jones argued that small caps are still a good ‘value’ play, with a price-to-book ratio well below their large cap peers.

Investors have also taken notice. Small cap ETFs have attracted $8.4 billion in net inflows so far this year while large-cap ETFs have brought in $13.3 billion. To put this in perspective, small cap ETFs saw $29.5 billion in inflows over the past 12 months, compared to the $40.8 billion for large cap ETFs.

Jones also highlighted the diversification benefits of small-cap exposure. “More industries are contributing to Small Cap compared to Large Cap, which is dominated by Technology,” Jones stated.

John Lewis, Senior Portfolio Manager, Nasdaq Dorsey Wright, also pointed out that the dominance in the U.S. large cap growth style over the years has contributed to this category’s pricier valuations. The U.S. large cap growth was the best style in six of the past seven years, and SPY has been in the top three for five of the past seven years as well.

As a way to target these smaller markets, investors can consider funds like the First Trust Dorsey Wright DALI 1 ETF (NasdaqGM: DALI), which incorporates a relative strength strategy to home in on market segments with the highest forward momentum. The First Trust Dorsey Wright DALI 1 ETF tries to reflect the performance of the Nasdaq Dorsey Wright DALI 1 Index, which consists exclusively of U.S.-listed exchange-traded funds across four broad asset classes, including U.S. equity securities, international equity securities, fixed income securities, and commodities. The Index seeks to determine which of the four is most likely to experience the best investment performance until the next Index evaluation date.

The composition of the underlying index is determined by the highest levels of ‘relative strength’ to screen for those companies with the best performance over the near-term. The relative strength calculation is an objective method of comparing two investment options to determine which of the two is exhibiting greater forward price momentum.

The Invesco DWA SmallCap Momentum Portfolio (NasdaqGM: DWAS) may also present an efficient way to access smaller stocks. DWAS follows the popular Dorsey, Wright & Associates proprietary selection methodology that is designed to identify small cap firms with positive relative strength characteristics in an attempt to follow companies with strong forward momentum.

The ETF follows the Dorsey Wright SmallCap Technical Leaders Index. DWAS’s index is designed to identify companies that demonstrate powerful relative strength characteristics based on that company’s market performance. Approximately 200 companies are selected for inclusion in the Index from the Nasdaq US Benchmark Index. At its core, DWAS is a momentum-based strategy – one that could prove rewarding if the recent small cap rally continues.

Rene Reyna, Head of Thematic and Specialty Product Strategy ETFs and Indexed Strategies, Invesco, explained that Relative Strength strives to identify when to buy and sell. Relative strength is based on objective and measurable technical market factors to select securities. It avoids implicit biases and interpretation of fundamental analysis. Additionally, it can enhance portfolio potential through use of technical analysis and Point & Figure Charting.

“Momentum is a price driven factor that seeks to take advantage of trends in asset prices created through investor behavioral bias,” Reyna said.

“Momentum has been empirically proven to persist in through varying economic conditions asset class and geographic markets,” he added.

Andrew Hull, Associate ETF Strategist, First Trust, also pointed to the First Trust AlphaDEX methodology as a way for investors to avoid the pitfalls of traditional capitalization-weighted investments.

“AlphaDEX is an index-based investment process that seeks to produce similar correlation and risk characteristics as broad market indexes while providing outperformance due to a unique stock selection and weighting methodology,” Hull said.

Specifically, AlphaDEX is a ‘merit-based’ approach that overweights stocks based on investment potential. It uses the findings available in the academic literature and seeks to earn alpha through a disciplined empirical approach.

The First Trust Small Cap Core AlphaDEX Fund (Nasdaq: FYX) ranks eligible small cap stocks from the NASDAQ US 700 Small Cap Index on growth factors including 3-, 6- 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. All stocks are ranked on the sum of ranks for the growth factors and, separately, all stocks are ranked on the sum of ranks for the value factors.

Financial advisors who are interested in learning more about small capitalization stocks can watch the webcast here on demand..