Scott Burns: Sector ETF investing with a small-cap twist. Hi there. I'm Scott Burns, director of ETF research with Morningstar. Joining me today is Ben Fulton, who runs the PowerShares Group. Ben, thanks for joining me.
Ben Fulton: Thanks, Scott.
Burns: So you guys are coming out with a very interesting new lineup of small-cap sector ETFs. One way people can think about these is they're like the baby SPDRs. Everyone knows the financial sector SPDR, and the energy sector SPDR, but this is a small cap version. Talk a little bit about where the cut-offs are for small cap. What's in these funds, and what can investors expect?
Fulton: We're real excited. We're working with S&P. It was S&P that created the SPDR family of products. We've worked with the S&P 600, which is their small cap index.
Burns: So just for our readers that aren't as familiar, there's the S&P 500, and that's with the sector SPDRs, which are distributed by the ALPS Group. Those are the sectors of the 500. And then there's the middle group.
Fulton: The mid cap S&P 400.
Burns: And the smallest group would be the S&P 600.
Fulton: Right. The S&P 600 are smaller companies. It's amazing. In the economy that we've just gone through, there are a lot of names that are familiar to people, names that you recognize and are used to.
Burns: We were joking on the team: AIG, Freddie, Fannie. If GM were actually still a tradable company, they'd be there.
Fulton: Yeah. Most of the restaurants you eat at on weekends are there. There's a lot financials, technology, healthcare. It's a very representative index. We're really excited about this timing.
Typically, coming out of a recession, you want to look for investment opportunities in the small cap area. These are companies that are small enough to figure out how to navigate and possibly improve the stock price a little quicker than a large company.
Burns: So you think that will still prove true, given that we're still in the junk rally, as a lot of people think? Has that happened already?
Fulton: Well you've had some movement. In the last six or eighth months, there has been some pretty good movement in small cap. As I keep saying, people are looking small. They're either looking at emerging market, or they're looking at small cap.
Small cap, though, has been only available in the ETF form, in broader small cap sector, or growth and value. This allows you now to be a little more specific, if there's a certain sector that you need exposure, or you need an opportunity and now you can take a sector look at the marketplace. It's the first of its kind.Read Full Transcript
Burns: So with any ETF, whether large cap or small cap, our research mantra is always: "Know what you own. Know what you own. Know what you own." Is there concentration risk? Is there anything that folks have to be aware of that would be different, or maybe unique to a small cap version of these sector funds?
Fulton: Well as much as possible, we try to look across and get good representation. You have some of the small-cap sectors that have may have fewer shares. Some got down to as few as 20 names in the portfolio, and some are as large as 114 names in the portfolio.
So you've got a little bit of a range of products. You definitely want to look at that and recognize that. But we think it's a very liquid market. The way S&P - in their selection process and liquidity - looks at it provides a lot of opportunity for the PMs to be able to track the index, manage it, and provide, we hope, a very enjoyable investing opportunity.
Burns: ETF liquidity is a big concern right now for anybody. There are the folks that say as long as ETF is liquid, it doesn't matter. There are some other folks that say as long as the underlying is liquid, it doesn't matter. What do you expect the investing experience to be like for these small-cap sector funds?
Fulton: First of all, it will be a fully-replicated portfolio. As we look in and we stress test the portfolio, it should be able to trade easily, and be able to grow to a larger size without any risk to the investors, so you have a lot of underlying price movement. But we'll continue to watch and monitor that. And I will say the index providers today do the same thing, where they look and realize the effect.
At the end of the day, with small cap, the one thing we all know is that a company's stock continues to move. Their goal is to become mid caps and grow up out of this, and new names come in. So you see quite a bit of turnover. The turnover rate on small caps is going to be a little higher than we've seen historically in the large cap areas.
Burns: Do you think that will create taxable gain distributions or anything?
Fulton: We think we can manage through it, but that's something you always have to work hard with. But ETFs, as a whole in the industry, have done a very good job of being able to look at those, and especially try to figure out where capital gains are at, and harvest those loses as much as possible.
Burns: I will tell you that we did our study on ETFs and whether or not they delivered on that tax efficiency promise. And there were two out of 26 categories where they didn't, and they were small cap names. So watch out.
Fulton: It is tough. A good heads up, we appreciate that.
Burns: No problem. As always with small caps, there's going to be a little more volatility in general. One last concern is does the index adjust for low-float? I think that's always a concern with small-caps. You get that ability for either the folks that started up the company, or a large investor to really shrink the tradability of the underlying security. Is that adjusted for?
Fulton: It's deemed a modified cap-weighting, but one of the areas they look at is float. And you are right, with small cap companies you can end up having one single, large buyer or some shares that are held out. That's looked at and addressed through this, at least through the 600 it is.
Burns: Berkshire just got out of the S&P 500, so I guess S&P's keeping an eye on that. Well, Ben, thanks for joining me, and good luck with those funds. We'll talk to you later.
Fulton: Thanks, Scott.
Burns: I'm Scott Burns, director of ETF research for Morningstar. For this and other ETF news and commentary, please check out the ETF Center on morningstar.com and Morningstar's ETF Investor Newsletter.