OT: Looking For Tiny Treasures
By GREG NEWTON
FROM FAMINE TO FEAST: Suddenly, investors in U.S. exchange-traded funds have three micro-cap ETFs to choose from -- versus none just a few months ago.
But those with a taste for the most speculative end of the stock market need to understand the very distinct differences between these products, which are based on newly compiled indexes that have little in common with one another besides the "micro-cap" in their names.
The very nature of the micro-cap segment means that the ETFs will be more volatile, and have greater portfolio turnover, than other ETFs. The sector's liquidity constraints will make it more difficult for managers to track their benchmarks accurately. And it's likely that, given the combination of liquidity issues and lack of appropriate hedging vehicles available to market-makers, retail investors will find it difficult, if not impossible, to short the ETFs.
The reasons for the rush to market are clear. The micro-cap fund sector to date has been poorly served, with just a handful of mutual funds; screening tools on Morningstar's Website, for example, do not offer 'micro-cap' as a selection option.
And, then, of course, there's performance: "The most sizzling segment of the market" is how leading index-provider Russell breathlessly described the 7.1% gain in its new micro-cap index in July, just a month after its introduction.
Over the longer term, Russell's MicroCap Index underperformed both the broad market and small-caps in the 12 months ended August 31, but its 9.84% annualized
gain over five years handily outpaces the small-cap Russell 2000's 5.75% annualized gain, and the broader-market Russell 3000's annualized loss of 1.81%.
Meanwhile, the other newly announced micro-cap indexes, from Dow Jones (the publisher of Barron's) and Zacks, have outperformed Russell's model over most timeframes.
The first micro-cap ETF to trade in the United States was Barclays Global Investors iShares Russell MicroCap Index Fund (ticker: IWC), listed on the New York Stock Exchange on August 16.
It was quickly followed by the PowerShares Zacks MicroCap Portfolio (PZI), which began trading on the American Stock Exchange on Aug. 18.
And the Dow Jones Select MicroCap Fund (FDM), the first ETF managed by suburban Chicago-based First Trust Advisors, began trading on the Amex Friday.
THE FIRST CHALLENGE FACING THE PROSPECTIVE investor is tracking down just what each of the competing indexes are, in fact, tracking -- a task not helped by the inconsistent manner in which information about the funds is presented, and the amount of information available, on the providers' Websites.
The Russell MicroCap index, which was announced May 26, covering 2000 stocks, effectively ranked from 2001 to 4000 by market-cap size, in the Russell U.S. market universe. Its U.S. focus does, however, mean that it avoids both non-U.S. incorporated companies and foreign stocks, including American depositary receipts, and certain corporate structures, including limited partnerships and royalty trusts.
The Dow Jones index is based on a subset of the broad Dow Jones-Wilshire MicroCap index, effectively covering the stocks ranked from 2501-5000 in the broad Dow Jones-Wilshire 5000 index. Zacks selects from the smallest 2500 stocks in its own database.
Beyond that, the Dow Jones Select MicroCap Index subjects its list to a series of screens intended to identify stocks "that are comparatively liquid and have strong fundamentals relative to the micro-cap segment as a whole." The index currently has 280 stocks.
And while both the Russell and Dow Jones indexes essentially are capitalization-weighted, Zacks uses a modified equal-weighting on its constituents, which are "strategically" selected by a proprietary model that focuses on value, momentum and liquidity, with the aim of outperforming passive micro-cap strategies. Zacks currently has around 340 stocks in its index; its selection process is intended to yield "300 to 500" stocks.
The indexes are tightly correlated with each other, but their different design parameters produce significant performance fluctuations (see table, Drilling Down) over most time frames.
Tables: Drilling Down
Varying Sector Allocations
Different Top HoldingsLori Richards, senior product manager for the Russell indexes, said that its micro-cap ETF product is designed to help investors accurately measure a specific market segment. By contrast, both of its competitors are picking relatively few stocks, in the hope they will outperform. And, in not-so-veiled criticism of the methodology used to assemble the Dow Jones and Zacks indexes, Richards points out that past performance records are "like picking the right lottery numbers after they are known to the world.
"Investors need to determine if they want passive vehicles reflecting the broadly diversified market or if they want to bear active risk and hire professional active managers, or actively managed indexes," she affirms.
The impact of the design variation is perhaps most evident in the sector allocations (see table, Varying Sector Allocations). Financials are the only sector to make the top three allocation of all three indexes, while health-care allocations, for example, range from 8.4% to 17.5%. Top 10 index holdings (see table, Different Top Holdings ) tell a similar story, with no company making it onto more than one of the Top 10 holdings lists.
By contrast, five mega-cap companies -- ExxonMobil, Intel, IBM, Johnson & Johnson and Microsoft -- appear in the Top 10 holdings of two of the three major U.S. market indexes.
The argument for micro-cap index investing is essentially based on the asset-allocation benefits of the sector's low correlation with large-cap stocks. A Zacks white paper says that micro-caps have a 60% correlation with the Dow Jones Wilshire large-cap index over the last 15 years. "Because of this, the addition of micro-cap stocks to a diversified portfolio of equities should improve risk-adjusted performance," says a Zacks white paper.
But getting at those benefits -- ac- cording to Zacks, a 10% allocation over the last 10 years would have produced another 0.81 percentage points of average annual return, while very slightly reducing volatility -- has been tough until now.
Investors have had to choose from a handful of conventional mutual funds, or venture into waters where volatility, liquidity issues and the limited (and sometimes even-more-dubious than usual) analyst coverage make individual stock-picking more dangerous.
DAVID COHEN, WHO AS ZACKS' managing director for index strategies was responsible for developing its micro-cap index, said that the overwhelming evidence is that long-term micro-cap returns come from "uninspired, relatively cheap stocks that become consistent earners," rather than the headline-grabbing high-fliers that vault into more respectable capitalizations.
The sector's liquidity issues will be among the biggest challenges facing the managers as they attempt to accurately track their benchmarks. That factor helps explain why a relatively small number of stocks have been selected for the Dow Jones and Zacks indexes that were designed to fit the ETF concept.
By contrast, iShares, whose "customized subset" of the Russell index has more than four times the number of stocks than the other comparable ETFs, will be relying on its proven sampling and optimization processes to limit tracking errors.
Turnover will be another challenge, especially if the ETFs begin accumulating significant assets and -- as has happened with other ETFs -- fast-moving hedge funds begin to dominate trading. As noted by Barron's August 22 Up and Down Wall Street column, it may become a question of whether stocks are driving the ETFs, or the ETFs end up driving the stocks.
"Whatever the recipe, it will be interesting to see if the momentum players who have piled into the small-cap ETFs barrel into the micro-cap numbers. And what will the effect be if they all try to make for the exits at the same time?" said Randall Forsyth in that column.
Zacks' Cohen is aggressively unapologetic about the firm's quarterly reconstitution schedule, compared with the annual schedule of its competitors. As well, his index dropped five stocks before its ETF had traded a full week -- and one of its largest holdings had already blown through the top of the initial capitalization range.
"We have every intention of having higher turnover. We're looking for performance, and we're going to be very aggressive about replacing relatively poor performers with better performers when we rebalance," he says.
The battle for market share between the iShares and PowerShares ETFs has yet to resolve itself. Yet somewhat surprisingly -- given the Goliath-like footprint of the Russell/iShares combination in indexes and ETFs, respectively, compared with the Zacks/PowerShares' barely Davidian presence -- the PowerShares ETF has dominated the early running, with assets of more than $85 million at the close of business on Sept. 28, compared with the $50 million in the iShares product.
PowerShares has also led the share-volume race since its launch, with an average daily volume of almost 160,000 shares, compared with fewer than 50,000 shares for the iShares product. However, that lead almost disappears when it is adjusted for share price: the PowerShares product closed at 14.81 on Wednesday, or less than a third of the iShares' 50.05. iShares' average volume would, however, have been under 40,000, were it not for a single day when it traded 328,700 shares, according to Yahoo! Finance statistics.
Despite that, the performance of the two products since their respective launch dates has been largely flat, with the iShares losing 0.4% and the PowerShares up 0.54%. And while PowerShares would doubtless claim that it has outperformed its competitor, with a record of just 29 trading days, it's rather too early to claim that its ETF will match the long-term record of the Zacks index against its Russell counterpart.
How the arrival of the First Trust/Dow Jones ETF will affect the competitive dynamic is uncertain, but last-to-market products rarely have an easy time making progress in a competitive market. As well, First Trust must overcome the disadvantage of being an unknown in the ETF world -- where PowerShares' success amid the iShares, State Streets and Vanguards is an almost classic example of the exception proving the rule.
The new micro-cap ETFs allow an investor to simply add an important market segment to an equity portfolio. But that investor needs to clearly understand that the ETFs are no mere clones -- and that they may, in real-time market hurly-burly, behave very differently.
