Heating Up

Micro Cap Stock Exchange Traded Funds (ETFs) Coming To A Portfolio Near You

Micro cap stock exchange traded funds (ETFs) have been around for a while now. Yet, I'm still surprised how many traders look a little shocked that the fast-growing ETF world now actually includes something from the small end of the market cap scale. Moreover, considering most true micro cap mutual funds (of the traditional variety) are already closed - or soon will be - it just seems like these relatively liquid investments would get more attention. But, since they don't, I'll make a modest plug for micro cap ETFs today.

If you're wondering why I decided to have the micro cap ETF chat in the 'Heating Up' column, my rationale is simple enough - the volume and interest in them is growing - or 'heating up'...at least enough to make them a viable investment choice. In fact, we're starting to see two of the three key micro cap ETFs trade tens of thousands of share per day. The third is still a little iffy in terms of liquidity for any large investment portfolio, but still worth watching, I believe.

We'll look at each one of the three in detail in a moment. Before we got into any of that discussion though, I wanted to make a couple of quick points about what I think these ETFs are good for, and not good for.

From my point of view, any of these ETFs are great for philosophical strategies, or as part of an allocation/rotation methodology. What the heck does that mean? It just means if you or your advisor adjust your portfolio's pie chart on a regular basis in response to external influences, then you could get some good out of these instruments.

As an example, consider a recession as an external influence. While most large cap stocks don't do well in a recession, the average small or micro cap stock can usually at least hold its own if not thrive in economic weakness. So, when recession strikes, you could rotate into (or overweight) a micro cap ETF, and scale back on large-cap holdings.

ETFs like these, however, may fall short of your expectations if you're using them to speculate and expecting big gains from them.

Remember, these are basically index funds. There's nothing wrong with index funds as part of an allocation strategy (as we previously discussed), but it's not like these securities could ever offer up a grand-slam trade in a short-period of time. If you really want a chance at a few homeruns, I still say the best option is individual small cap stocks. If you need help finding them, look no further than our newsletter - that's our specialty.

OK, with those ideas swimming around in your head, here are three individual micro cap ETFs I suggest you keep in your back pocket for a rainy day.

PowerShares Zacks Microcap Portfolio (PZI). This ETF is designed to mirror the Zacks Micro Cap Index (ZAX), which isn't exactly an index. Potential candidates for inclusion in the index are the 2500 smallest listed U.S. companies. Zacks then uses a proprietary filter to narrow the list down to the best 300 to 500 stocks in that group. It's not 'actively' traded though, so it's essentially an index as far as we need it to be.

Volume is decent - usually between 50,000 and 200,000 shares trade every day. That leaves them out of reach for most fund managers, but the average retail investor should be able to purchase as much as he or she wants.

iShares Russell Microcap Fund (IWC). This may be the most well-known ETF of the three we're looking at today. The iShares Russell Microcap ETF is a proxy for the smallest 1000 companies in the Russell 2000, plus the next 1000 smallest companies. So, in terms of market cap, IWC represents companies #2001 through #4000 among U.S. listed stocks. That's about 3% of the total market in the United States.

The volume here is about the same as PZI's...anywhere between 50,000 and 200,000 shares per day.

First Trust Dow Jones Select Microcap (FDM). This is by far the least actively traded micro cap ETF of the three; only a few hundred to a few thousand shares trade per day, as of right now. That may be enough to dabble in, but could be limiting for a portfolio of significant size. Still, it's an alternative to the other two - if needed.

The ETF is designed to mirror the Dow Jones Select Microcap Index. The Dow Joes Company hasn't clearly defined how this index is constructed, but the description suggests it incorporate the 'middle' portion of all U.S. listed stocks. Though not 'managed', the constituents are ultimately hand-picked using fundamental-based criteria.

Let me stress again...these ETFs are never going to be the stuff of high-octane trades - they just don't have the power to make explosive moves like the right small or micro cap stock can. If you want the big wins, you have to go straight to the source - individual equities.

All the same, I think these three instruments finally have or are gathering enough followers to be liquid, even for larger portfolios. If you're looking for a broad arena that's largely uncorrelated to other market segments, I suggest you start your search with those three tools.