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If you’re bullish on the global economy, small-cap exchange-traded funds are potentially a low-cost, diversified way to outperform broader equity benchmarks. At least, that’s the general theory behind investing in small-cap stocks, which can range between $100-million and more than $3-billion in market capitalization, depending on the index.

“This theory that small-caps should outperform larger-caps is based on something called the ‘size effect,’” says Alan Fustey, portfolio manager with Adaptive ETF in Winnipeg, a division of Bellwether Investment Management Inc.

The size effect is based on the notion that smaller firms – if successful – should have more room to grow by market capitalization than large-cap stocks, which are typically slow-growing and involve less risk and volatility. Conversely, small-cap firms are generally riskier and more volatile and “financial market theories generally hold that more risk should get long-term better returns,” Mr. Fustey says.

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However, he notes that hasn’t been the case in recent years. Over the last five years, the Russell 2000 Index – the broadest small-cap index in the U.S – trailed the S&P 500 Index. The S&P 500 grew by almost 60 per cent between Jan. 23, 2015 and Jan. 10, 2020, while the small-cap benchmark grew by about 40 per cent.

Longer-term, the Russell 2000 has outperformed the S&P 500, growing by more than 326 per cent compared to about 222 per cent for the broader index, as of Jan. 10. In a recent Bloomberg survey, four of five strategists forecasted the small-cap index to outperform the S&P 500 in 2020.

Investors seeking small-cap exposure through ETFs have a number of options to choose from. Here are five funds to consider, based on interviews with three market experts:

SPDR S&P 600 Small-cap ETF (SLY)

A market-cap-weighted ETF with a 0.15 per cent management-expense ratio (MER), SLY follows the S&P SmallCap 600 Index instead of the Russell 2000.

Gordon Ross, a portfolio manager with Vancouver-based, believes ETFs tracking the S&P SmallCap 600 Index are likely to outperform those mirroring the Russell 2000 because the S&P 600 employs a handful of criteria to determine constituents besides just market-cap weighting. The SLY also adds and subtracts companies on an as-needed basis, while the Russell 2000 ranks the top 2,000 small-caps in the U.S. according to the market-cap weighting each June.

Since reconstitution occurs at the same time annually, many holdings experience downward price pressure as “fund managers are forced to sell winners and buy losers, thereby creating a negative momentum portfolio,” according to a 2015 study by S&P Dow Jones Indices Research.

Over the last five years, for example, the S&P 600 has increased by more than 47 per cent while the Russell 2000 is up about 40 per cent (all performance data as of Jan. 10). Investors who still prefer the broader diversification of the Russell 2000 can find plenty of low-cost ETF options, including the iShares U.S. Small-cap Index ETF (CAD-Hedged) (XSU) with a 0.36 MER.

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The SLY has returned about 15 per cent over the past year and about 10 per cent and 13 per cent annualized over the past five and 10 years, respectively.

WisdomTree U.S. SmallCap Dividend Fund (DES)

A dividend screen can seem like an ill-advised strategy for small-caps, says David Kletz, a portfolio manager with Forstrong Global Asset Management Inc. in Toronto. “The classical small-cap company is an early-stage firm that needs to invest all its capital in growth opportunities,” he says.

However, he notes the need to pay dividends can “force management to be disciplined managing cash flows.”

While DES is a less volatile investment than SLY, its performance has lagged, with a one-year return of 10 per cent, and annualized five- and 10-year returns of about 7 and 11 per cent.

While the DES MER is more than double SLY’s at 0.38 per cent, its yield is also higher at 2.73-per cent versus 1.63 per cent for SLY, making it attractive to income-seeking investors.

iShares MSCI EAFE Small-Cap ETF (SCZ)

Growth investors seeking exposure outside of the U.S. can look to SCZ, a diversified basket of small-cap stocks from Europe, Australia, Japan and other developed markets in the Far East such as Hong Kong, Mr. Kletz says. These markets have generally lagged behind the U.S. in their recovery after the 2008-2009 global financial crisis. With fears of a global trade war subsiding, he says their broader markets could outperform in 2020.

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“If you are convinced of this investment case, you could go a step further into the small-cap sector, which tends to be a higher beta,” Mr. Kletz says, adding beta refers to the performance of the standard benchmark of large-cap stocks for the region.

Offering exposure to more than 2,300 companies across mostly Western Europe, Japan and Australia, SCZ has 0.4 per cent MER and a one-year return exceeding 18 per cent, and an annualized return of more than 8 per cent over the last 10 years.

iShares S&P/TSX Small Cap Index ETF (XCS)

The Canadian small-cap market has not been as rewarding as the U.S. and international opportunities, Mr. Fustey says.

The reason: “In Canada, when you start getting into small-cap, you’re overweighting oil stocks and mining,” he says. Both sectors continue to struggle – and Canada’s small-cap market along with them.

Over the last decade, XCS has seen an annualized return of less than 3 per cent. And with a 0.6 per cent MER, the ETF is costly, given “you can buy the TSX 60 index for just seven basis points,” Mr. Fustey adds.

Still, Canada’s small-caps may be on the upswing, with XCS posting about 16 per cent return in 2019.

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Vanguard FTSE All World ex US Small-cap Index ETF (VSS)

VSS could be a good fit for investors seeking a combination of Canadian and international small-caps, excluding the U.S. market, Mr. Fustey says. The Vanguard offering has about 14 per cent of assets under management allocated to Canadian firms.

“If you wanted diversified global approach with some exposure to Canada, you’d probably be better off with the Vanguard product paired with a U.S. small-cap ETF,” like the iShares Core S&P Small-cap Index ETF (IJR), which has an MER of 7 basis points. “You’d still get Canadian exposure, only less concentrated in energy and minerals than a Canadian small-cap ETF.”

The VSS is low cost, too, with a 0.12 per cent MER. It also provides diversified exposure to more than 3,900 stocks across emerging markets, Europe, Japan and North America with Canadian firms Open Text Corp., Emera Inc. and Kirkland Lake Gold Ltd. among its top holdings. VSS has returned about 16 per cent over the past year and a 10-year annualized return of about 5.6 per cent.

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