Finding growth with small-cap ETFs

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The weakness in the share market over the past year has not spared the small-cap sector. In the twelve months to January, the S&P/ASX200 index was down 10.3% in price terms, whereas the S&P Small Ordinaries index was down 15.9%.

This should be no surprise. As small company shares are less liquid and their business models are generally perceived to be at greater risk during an economic downturn, it’s often the case that small-cap stocks fall harder during market retreats. On the other hand, they also rise faster during rebounds.

At the height of the market’s post-GFC rebound earlier last year, for example, annual performance in the small-cap index was also 15 percentage points better than for the large-cap index. Yet during the GFC, the largest year on year price decline for small-caps was 60%, compared with 40% for large-caps.

It stands to reason, therefore, that when – and if – the market eventually rebounds, small-caps are likely to shine again. Indeed, so far this year the small-cap index has raced ahead by 11%, more than doubling the 4.9% gain by the large-caps.

What to buy

Of course, that begs the question of which small-cap stocks to buy? If you’re stumped for ideas and don’t want to drown in too much paperwork, one easy way to gain exposure to the smaller end of town is through one of several recently listed small-cap exchange-traded funds or ETFs. In a single trade, investors can now gain market exposure to all the stocks in the ASX Small Ordinaries index (for ETFs provided by State Street and iShares) or the MSCI Australian Shares Small Cap index (for Vanguard’s ETF).

In terms of long-run performance, the differences between these two underlying benchmarks is not great, so ETF selection come down to the cost, liquidity and the management experience behind what’s on offer.

As seen in the table below, Vanguard (again) has the cheapest small-cap ETF offering, with a management expense ratio (MER) of only 0.3%. Vanguard’s ETFs is the newest (less than a year old) and by the end of last month it had less than $10 million in funds under management (FUM). Yet despite this, liquidity was not bad, with an average bid-offer spread last month of only 0.37% and average bid depth of more than $2 million.

Vanguard’s offering is a good option. That said, all the small-cap ETFs are provided by large, established and very experienced providers and would provide a useful vehicle for gaining small-cap exposure.

Comparing small-cap ETFs

Not so small

Although these benchmark’s track so-called ‘small -cap’ stocks, these stocks are far from the smallest on the market. Indeed, the S&P Small Ordinaries index is defined as those companies in the S&P/ASX300 index, but not in the S&P/ASX100 index. In other words, the small-caps are in fact the next 200 largest stocks on the market by market capitalisation after the top 100 stocks. Indeed, their average market cap is currently around $1.4 billion!

Compared to the S&P/ASX200 index, moreover, the small-cap index tends to have relatively more industrial firms and fewer financials. By late February, financials accounted for a mere 9% of the ASX Small Ordinaries index, while industrials accounted for 18%. In the S&P/ASX200 index, the respective sector shares were 37% and 7%. And you’ll also get a bit more resource sector exposure, with materials accounting for 33% of the small-cap index and only 25% of the larger-cap index.

A final point to note is that while gaining small-cap exposure through ETFs is relatively cheap and easy, this tends to be one area of the market where good actively managed funds can more often beat the index – as information on small-cap stocks is relatively less well known across the market.

That suggests when, and if, the market finally turns higher, seeking out top performing small-cap funds and/or expert stocks pickers (as in the Switzer Super Report) can complement a small-cap ETF strategy in adding risk to your portfolio.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Also in the Switzer Super Report

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