Small-Cap ETFs: ‘US small-caps are benefiting as market recovers’

Apr 2nd, 2012 | By | Category: Equities

US small-cap stocks have benefited from the recent revival in the market.  Since the conclusion of the financial crisis, the asset class has been powered by central bank easing, improving economic conditions and fairly robust merger and acquisitions (M&A) activity.

Small-Cap ETFs - US small-caps are benefiting as market recovers

Christopher Berrier, a small-cap fund manager at Brown Advisory, says that cash-rich US corporates are increasingly targeting smaller US firms.

According to Christopher Berrier, Co-Portfolio Manager of the Brown Advisory US Smaller Companies Fund, he is seeing a substantial pick-up in interest in small-cap stocks among institutional investors who believe the asset class will continue to benefit from improving economic data in the US and global coordinated central bank easing.

Berrier believes that, “Whilst the European debt crisis remains a threat to global recovery, the recent LTROs appear to have, at least temporarily, arrested a potential banking crisis and small-cap US companies are relatively insulated from the events in Europe based on the majority of their revenues and operating profits being sourced domestically. Many believe that several downside risks have come off the table, so small-caps have done well, as they traditionally do.”

Berrier says that while the US seems set on what may be a very long road to full recovery, the anticipated strength and longevity of the present M&A cycle should support small-cap equities in the near-term. Cash-rich US corporates are increasingly targeting smaller firms profiting from powerful commercial trends, such as the tectonic shift to cloud computing, the proliferation of intelligent mobile devices and the growth in web-based social media in the technology sector.

FEATURED PRODUCT

iShares S&P SmallCap 600 ETF (ISP6)

– Provides diversified exposure to 600 US small-cap
stocks, representing approximately 3% of the US
domestic equities market

– Designed to be an efficient portfolio of companies
that meet specific inclusion criteria to ensure that
they are investable and financially viable

– Optimised physical replication with full transparency
to underlying holdings

– UCITS compliant, LSE listed, UK Reporting Status,
eligible for ISAs and SIPPs

– TER of just 0.40%, considerably less than
actively managed OEICs, SICAVs or Unit Trusts

“The top-down rationale for such M&A deals is simple. Larger companies possess rock solid, cash-rich balance sheets, near-record profit margins and access to cheap credit. What they lack is growth, and M&A provides the potential to strategically catalyse expansion, by opening up new markets whilst providing revenue and cost synergies,” he adds.

From an ETF perspective, in addition to the factors mentioned above, a further key advantage of investing in small-caps is that benchmark indices tend to be far more diversified and less dominated by individual companies or sectors. For example, the Russell 2000 Index, one of the most widely tracked US small-cap indices, contains almost 2000 individual stocks, of which the top ten holdings equate to just 2.51% of the index. By contrast, the large-cap S&P 500 Index is highly concentrated, with the top ten holdings accounting for a significant 20.44%.

All these benefits add up to make small-cap investing highly appealing and this is backed up by academic evidence which makes the case for small-caps, too. Indeed, numerous studies have pointed to a small-cap performance advantage, or so-called ‘small-cap premium’, whereby small-caps tend to outperform large-caps over the long term.

For UK-based investors looking to play this theme and access US small-caps, there are a number of London-listed ETFs to consider.

iShares S&P SmallCap 600 ETF (ISP6)

The iShares S&P SmallCap 600 ETF tracks the performance of the S&P SmallCap 600 Index. The S&P SmallCap 600 Index offers exposure to 600 small-cap US stocks which comply with S&P’s size, liquidity, and free float criteria. The index covers approximately 3% of the US domestic equities market. The index is designed to be an efficient portfolio of companies that meet specific inclusion criteria to ensure that they are investable and financially viable. These criteria include market cap (companies must have a market cap in the range of $300 million to $1.4 billion), public float (public float must exceed 50%) and financial viability (four consecutive quarters of positive earnings). TER 0.40%.

Credit Suisse MSCI USA Small Cap ETF (CUS1)

The Credit Suisse MSCI USA Small Cap ETF tracks the MSCI USA Small Cap Index. The MSCI USA Small Cap Index is an equity index of small-cap securities generally incorporated in the US and listed on either the New York Stock Exchange, NASDAQ or the American Stock Exchange. The index offers exposure to those stocks which rank below the MSCI USA Index measured by market capitalisation and comply with MSCI’s size, liquidity, and free float criteria. The index currently has c. 2000 constituents, comprising approximately the smallest 15% of the total investable market by market capitalisation. TER 0.43%

The following three funds track the Russell 2000 Index:

DB X-trackers Russell 2000 ETF  (XRU2)  TER 0.45%
Russell 2000 Source ETF  
(RTYS)  TER 0.45%
ETFX Russell 2000 US Small Cap ETF £  
(RTWP)  TER 0.45%

The Russell 2000 Index measures the performance of the small-cap segment of the US equity universe. It includes approximately 2000 companies. The index is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set. The index represents approximately 8% of the total market capitalisation of the US equity market, compared to approximately 3% for the S&P 600 Index.

For investors looking for exposure to US mid-caps stocks, which sit above small-caps but below large-caps, they might consider the following:

SPDR S&P 400 US Mid Cap ETF (SPY4)

The SPDR S&P 400 US Mid Cap ETF tracks the S&P Mid Cap 400 Index of mid-sized US companies. The S&P MidCap 400 Index is a float-adjusted, capitalisation weighted index of 400 securities, providing investors with a benchmark for mid-sized US companies. The index covers approximately 7% of the total US equity market and seeks to remain an accurate measure of mid-sized US companies, reflecting the risk and return characteristics of the broader mid-cap universe on an on-going basis. TER 0.30%.

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