Go Small For Big Gains

1/16/2017


Since the Nov. 8 election, microcap stocks have surged 18%, compared to 6% for the S&P 500 Index and 16% for the S&P SmallCap 600.

Why the outsized love for microcaps? Investors are betting that President-elect Donald Trump will cut taxes, relax regulations, and boost spending on infrastructure — moves that benefit small companies.

And there's more to like — the very smallest stocks historically outperform. From 1926 to 2015, microcaps delivered an annualized return of 12%, according to Morningstar. For comparison, large stocks returned 10% annually. Using Morningstar's methodology, the current maximum market capitalization for a microcap is $700 million.

Also, microcap returns are serially correlated, meaning they tend to perform well after periods in which they have performed well.

Microcaps have their drawbacks. The stocks are inherently volatile. The Russell Microcap Index has a standard deviation of 21% based on 120 months of returns ended December, versus 15% for the S&P 500 Index. For investors, there aren't a lot of microcap funds to choose from, and they tend to have higher expense ratios than other U.S. stock funds.

Still, microcap funds tend to outperform in strong markets. The table below lists eight attractive funds that invest mainly in the very smallest U.S. stocks.

MICROCAPS FUNDS GENERATE BIG RETURNS
Investors who can tolerate higher risk might consider microcap funds, including the eight listed below. First Trust Dow Jones Selected MicroCap tracks an index developed by Horizon Investment Services, a sister company of Horizon Publishing.

Average
Market
Capitalization
($Millions)

------- Total Return -------
2016
(%)
-- Annualized --
Fund (Price; Ticker)
5
Years
(%)
10
Years
(%)
Exp.
Ratio
(%)
Fund
Score
Exchange-traded funds
First Trust D.J. Select
MicroCap ($44; FDM)
454
35.9
17.6
7.4
0.60
99
iShares Micro-Cap ($86; IWC)
444
20.7
14.8
5.3
0.60
57
PowerShares Zacks Micro Cap
($19; PZI)
406
24.1
14.4
2.1
0.81
49
Wilshire Micro-Cap
($30; WMCR)
207
18.6
15.5
3.2
0.59
61
Mutual funds
Bridgeway Ultra-Small Co.
($15; BRSIX)
170
21.5
15.7
6.0
0.75
56
Oberweis Micro-Cap
($22; OBMCX)
632
24.6
17.1
6.5
1.72
77
Wasatch Micro Cap Value
($3; WAMVX)
523
12.4
15.3
8.2
1.95
56
Westcore Micro-Cap Opp.
($19; WTMIX)
634
24.5
14.5
NA
1.30
47

Only four exchange-traded funds (ETFs) track microcaps, including First Trust Dow Jones Selected MicroCap ($44; FDM), which mirrors an index designed by Horizon Investment Services — a sister company of Horizon Publishing. Horizon Investment Services is compensated for creating the index.

First Trust Dow Jones Selected Microcap invests in 274 stocks that have an average stock-market value of $454 million. The largest stock is valued at about $900 million, while the smallest is $54 million. The ETF is heavily weighted in financials (48% of assets), which account for eight of the top 10 holdings. The fund, with an impressive score of 99 in our rating system, has a reasonable expense ratio of 0.60%. In 2016, First Trust returned 35.9%, versus an average of 21.1% for the other three microcap ETFs.

OUR RECOMMENDED MUTUAL FUNDS

In 2016, our Conservative Portfolio gained 8.8%, compared to 8.2% for its passive benchmark. The Growth Portfolio returned 9.5%, versus 10.8% for its benchmark. Investors wishing to mimic our portfolios should purchase the funds listed below using the target weights.

----- 2016 * -----
Target Weights
Fund (Price; Ticker)
Total
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Fund
Rating
Baird Core Plus Bond ($12; BCOSX)
4.5
A
9
4
90
Dreyfus MidCap Index ($35; PESPX)
20.2
A
0
0
85
Dreyfus Small Cap Stock Index
($30; DISSX)
25.8
A
0
0
95
Fidelity Overseas ($40; FOSFX)
(1.3)
D
9
9
81
iShares MSCI EAFE Small-Cap ETF
($51; SCZ)
2.6
C
4
6
79
PRIMECAP Odyssey Stock ($26; POSKX)
12.8
A
7
8
96
T. Rowe Price QM U.S. Small-Cap
($29; PRDSX)
11.3
C
4
4
93
Vanguard 500 Index ($209; VFINX)
11.8
B
9
10
77
Vanguard GNMA ($11; VFIIX)
1.9
A
0
0
98
Vanguard Growth Index ($59; VIGRX)
6.0
B
10
11
84
Vanguard High-Yield Corp.
($6; VWEHX)
11.2
D
5
6
97
Vanguard Inter.-Term Tax Exempt
($14; VWITX)
0.1
B
0
0
85
Vanguard Mid-Cap Value ($39; VMVIX)
15.1
D
7
10
82
Vanguard Short-Term Invest.
Grade ($11; VFSTX)
2.7
B
9
4
99
Vanguard Small Cap Value Index
($29; VISVX)
24.7
D
4
4
93
Vanguard Strategic Small-Cap
($35 VSTCX)
20.6
C
4
4
93
Vanguard Total Bond Mkt. Index
($11; VBMFX)
2.5
D
0
0
39
Vanguard Value Index ($36; VIVAX)
16.8
B
9
10
98
Vanguard Wellesley Income
($26; VWINX)
8.1
B
0
0
99
Vanguard Wellington ($39; VWELX)
11.0
A
10
10
100
* Through Dec. 30. Ranks compare funds with same objectives: A = top 20%; B = next 20%; C= middle 20%; D = next 20%; E = bottom 20%. Fund ratings are percentile ranks, with 100 the best.

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