Micro-Cap ETFs Under the Microscope

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 --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.

Meanwhile the Powershares ETF, like most of the family's other offerings, tracks an index that has a twist of active management. The fund apes a benchmark assembled by Zacks Investment Research that relies on value and momentum factors to select stocks that will outperform the broader micro-cap universe. The index, which reconstitutes itself based on its screens four times a year and kicks out on a weekly basis constituents that cease to meet its standards, should have pretty high turnover for an index fund.

Curb Your Enthusiasm
You should still be wary of these offerings not only for all the reasons you should be guarded about any unproven funds, but also because it's not clear how they will handle liquidity in what historically has been one of the less liquid corners of the market. An ETF's shares are only as liquid as the fund's underlying holdings. Because of the way ETFs are structured, it's easier for large discrepancies to emerge between an ETF's market price and the net asset value of its holdings when the ETF owns thinly traded stocks. That's because ETFs rely on large institutional strength investors (or authorized participants) to use the fund's in-kind creation/redemption process to arbitrage away premiums and discounts by opportunistically trading baskets of the portfolio's securities for ETF shares and vice versa. It's easier to do that for large, frequently traded stocks, such as members of the S&P 500, than it is for micro-caps, which tend to have weaker trading volumes.

Capacity could be an issue, too. Most index funds don't face size constraints because their low turnover and broad diversification allow them to manage a lot of money. It's hard to say if, as these funds grow larger, they will be able to continue to invest in micro-caps without negatively impacting their prices.

Barclays and Powershares, of course, contend their funds have liquidity screens in place that ensure authorized participants will have no problem assembling creation units to match their fund's holdings. They also argue there is plenty of capacity, pointing out there is about $500 billion in total market capitalization in the micro-cap space and about $10 billion in micro-cap funds. Both hold up DFA U.S. Micro Cap, which has $3.8 billion, as proof that it's possible to run a big, passive micro-cap fund.

That may be true in the current environment, which has seen micro-cap trading volumes increase and bid/ask spreads narrow as strong performance has attracted money to the asset class. What happens if or when volume and spreads return to historical norms? Will there be enough liquidity to keep the funds from experiencing big premiums and discounts to NAV? Time and the trading ability of the funds' advisors well tell. In the meantime investors should let these micro-cap ETFs build longer track records before deciding if they are worth their money.  

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Disclosure: Barclays Global Investors (BGI), which is owned by Barclays, currently licenses Morningstar's 16 style-based indexes for use in BGI's iShares exchange-traded funds. iShares are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in iShares that are based on Morningstar indexes.