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Micro-Cap ETFs Under the Microscope

These two new micro-cap ETFs are intriguing, but unproven.

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The sponsors of two new micro-cap exchange-traded funds would have investors believe that if small is good, micro must be better. That certainly has been the case in recent years as tiny stocks have rallied, and there is a lot of research suggesting smaller stocks can produce bigger returns than their larger-cap brethren over the long term. That's not likely to occur without some gut-wrenching performance swings in this volatile asset class, though. It's also not clear if the recently launched micro-cap ETFs will be the best way to maximize any micro-cap strength.

Welcome Competition
Two micro cap ETFs--iShares Russell Microcap Index (IWC) and PowerShares Zacks Micro Cap Portfolio (PZI)--launched in August, and others tracking Dow Jones and MSCI micro-cap benchmarks could emerge in the future. Though launching micro-cap funds after five years of strong small- and micro-cap stock performance is questionable, the new funds do introduce some welcome price competition. Traditional micro-cap funds tend to be costly, with an average no-load expense ratio of 1.6% and broker-sold levy of 2.3%. As if that wasn't bad enough, the cheapest micro-cap option,  DFA U.S. Micro Cap (DFSCX), is difficult for small investors to get at due to its $2 million minimum investment. With expense ratios of 0.6% and wide availability through online brokerages, the micro-cap ETFs make the asset class more affordable and accessible.

Better Mousetraps?
I also think both offerings have intriguing approaches. The iShares Russell Microcap tracks the smallest 1,000 denizens of the Russell 2000 along with the next 2,000 smallest stocks. The fund, however, won't own all of those securities, whose market caps range from $50 million to $550 million. Instead it follows a modified version of the Russell Microcap that tosses out companies whose stocks fail to maintain cumulative monthly trading volumes of 125,000 shares for six consecutive months. That and representative sampling whittles the ETF's holdings down to about 1,200 companies, which advisor Barclays Global Investors contends is enough to ensure liquidity and diversification.

Dan Culloton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.