Smaller-company stocks offer better growth potential than their larger-cap cousins, but they often come with additional risk and volatility.
Exchange-traded funds (ETFs), which track an index of stocks, however, can give exposure to this sector without the wild swings from owning individual names.
Owning smaller-cap equities can help diversify an investment portfolio because there are times when they can outperform. Because smaller firms usually have a domestic focus versus multinationals, they can show strength during times of robust economic growth. Often known as the "January effect," small-cap stocks can also rally in the new year after year-end tax-loss selling is over, and fund managers look for riskier stocks with higher returns to help boost performance.
And now, some U.S. small-cap stocks may get a further boost if President Donald Trump gets the nod for his proposed corporate tax cuts that could lift earnings.
We asked three ETF analysts for their top picks in the small-cap universe.
- Alex Bryan, ETF and mutual fund analyst at Morningstar Inc., Chicago
- The pick: PowerShares S&P SmallCap Low Volatility Portfolio ETF
- Management expense ratio (MER): 0.25 per cent
This ETF is a defensive play on U.S. smaller-cap companies because it tracks stocks with lower volatility, says Mr. Bryan. "It is designed for risk-averse investors."
The fund, which holds 120 of the least volatile stocks in the S&P SmallCap 600 Index, has managed to post "competitive returns" compared with that benchmark, he noted. While the ETF has outpaced that index over the past three years, investors should not expect that outperformance to continue as stock valuations are higher now than a few years ago, he said.
"But if there is a market correction, that ETF should give investors a smoother ride than the broader market over all." Because the fund is half invested in the interest-sensitive financial and real estate sectors, rising rates can be a risk, he said. "That is something to be mindful of."
- The pick: SPDR S&P 600 Small Cap Value ETF
- MER: 0.15 per cent
This ETF invests in the cheaper names in the S&P SmallCap 600 Index but the result is still a fairly diversified portfolio, says Mr. Bryan.
The ETF, which tracks about 440 value stocks, includes such names as ALLETE Inc., Spire Inc., FirstCash Inc. and Lithia Motors Inc. However, some firms can trade at lower valuations because they face poor growth prospects or other problems, he cautioned. "This fund is going to be more volatile than a large-cap or broadly diversified small-cap strategy."
Any time the universe is split between growth and value, there will be periods when an investment style will or won't work well, he added. "That being said, stocks trading at lower valuations have tended to outperform over the longer term. … This fund is suited to more aggressive investors."
- Daniel Straus, ETF analyst at National Bank Financial Inc., Toronto
- The pick: iShares Core S&P S&P Small-Cap ETF
- MER: 0.07 per cent
This ETF is an ideal way to get exposure to U.S. small-cap stocks because it has a low fee and tracks an index that screens for higher-quality companies, says Mr. Straus.
The S&P SmallCap 600 Index is governed by a committee that uses criteria, such as "financial viability," to remove riskier companies, he noted. Over 10 years ended Oct. 31, the S&P SmallCap 600 Index has averaged 9.2 per cent annually, including dividends, versus 7.5 per cent for the large-cap S&P 500 Index.
The ETF's holdings include MKS Instruments Inc., HealthCare Services Inc. and Lumentum Holdings Inc. The fund is suited to growth-oriented or aggressive investors who don't own ETFs tracking the total U.S. market, he said. "Some of these ETFs have 15-per-cent exposure to small and mid-caps."
- The pick: Vanguard FTSE All World ex-US Small-Cap ETF
- MER: 0.13 per cent
This low-fee ETF, which tracks more than 3,500 small-cap stocks outside the United States, could be one-stop shopping for diversification, says Mr. Straus. Many investors likely have "large-cap exposure pretty well covered through main benchmark-tracking index ETFs," he said.
This Vanguard ETF, which would complement an investment in the iShares Core S&P Small-Cap ETF, is appropriate for growth-oriented or aggressive investors, he noted. However, the Vanguard ETF is also 13 per cent invested in Canadian companies, such as Gildan Activewear Inc., Keyera Corp. and H&R REIT. Investors need to be mindful of potential overlap with their other Canadian equity funds, or consider investing in international small-cap ETFs that exclude North American stocks, he said.
- Denise Davids, ETF and mutual fund analyst at Industrial Alliance Securities Inc., Toronto
- The pick: Vanguard Small-Cap ETF
- MER: 0.06 per cent
This ETF tracks more than 1,400 companies, and is a very low-cost way to get exposure to U.S. smaller-company stocks, says Ms. Davids.
The fund, which mimics the CSRP U.S. Small Cap Index, includes firms such as Teleflex Inc., Diamondback Energy Inc. and Chemours Co. Because the cash flow and earnings of smaller firms tend to be less stable than their larger peers, small-cap stocks are "more sensitive to unexpected market shocks," she noted. A decline in earnings growth or slower-than-expected economic expansion could potentially hurt the fund, she said.
Failure by the Trump administration to implement corporate tax cuts is also a risk because that expectation may be priced into stocks, she added. This ETF, she said, is better suited to investors who can tolerate some volatility.
- The pick: iShares Russell 2000 Value ETF
- MER: 0.24 per cent
This ETF may appeal to investors concerned about valuation because it gives exposure to nearly 1,390 of the cheaper U.S. small-company stocks, says Ms. Davids. Many smaller-cap names have "rallied quite significantly" on expectations of corporate tax cuts under the Trump administration, she noted. The fund uses criteria, including price-to-book value, to screen for stocks with low valuations.
The ETF's top holdings include MGIC Investment Corp., Wintrust Financial Corp. and Hancock Holding Co. Slower earnings growth and lower-than-expected economic growth are risks to the ETF, she said. Some stocks could also be "value traps" as their price may reflect business difficulties, she noted. This fund, she said, is appropriate for investors who can tolerate some volatility.