Owing in part to the asset class’s compelling growth prospects, small- and mid-cap stocks have long lured investors looking for more rapid upside potential than is offered by large-caps.
Of course, there’s a trade-off: Smaller stocks are usually riskier and more volatile than their large-cap counterparts. Investors need not fret because some exchange traded funds feature unique methodologies that allow market participants to access the upside prospects offered by smaller stocks while mitigating risk. The VanEck Morningstar SMID Moat ETF (CBOE: SMOT) is a leader in this conversation.
SMOT accomplishes some important objectives. First, it provides exposure to small- and mid-cap (SMID) stocks with wide moat traits — an attribute many investors don’t readily assign to those segments. Second, and directly related to the first, SMOT can potentially pare some of the risk associated with allocating to small-caps.
“Investing in stocks comes with risk, and that risk tends to be amplified in the small-cap market. Small companies offer the greatest potential for outperformance but also the greatest risk of loss,” noted Morningstar analyst Zachary Evens.
SMOT a Rare Small-Cap Gem
The ability of wide moat stocks to deliver over the long term is well documented. Some famed investors, namely Warren Buffett, embrace the style. Still, SMOT, which debuted last October, may not be getting the adulation it deserves when considering how difficult it is to efficiently locate SMID names with credible wide moat traits.
“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,” added Evens.
Indeed, smaller wide moat names aren’t as plentiful as large-cap equivalents. However, that doesn’t imply that SMOT is sparsely populated and highly concentrated. The opposite is true. The ETF is home to 100 stocks, with none of those holdings exceeding a weight of 1.83%, indicating that single-stock risk is low in the fund.
At the sector level, SMOT is fairly diverse. It features exposure to 10 of the 11 GICS sectors, with utilities being the exception. A cyclical tilt, as highlighted by a nearly 37% combined weight to consumer discretionary and industrial stocks, could work in SMOT’s favor in the back half of 2023.
“The relative size and competitive positioning of small-cap companies allow them to quickly capitalize on new business opportunities,” concluded 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.”
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