Smaller stocks are setting the pace for performance. In 2018, plenty of investors are worrying about the end of the bull market. Prospects of a global trade war, inflation fears and the general chaos in…
Smaller stocks are setting the pace for performance.
In 2018, plenty of investors are worrying about the end of the bull market. Prospects of a global trade war, inflation fears and the general chaos in the White House prompted more than a few hysterical headlines about how the end is near for stocks. But so far, there hasn’t been much in the way of losses for the typical investor. The S&P 500 is up 7 percent and many simply haven’t noticed the gains in large-cap stocks amid the negativity. Also, many more investors haven’t noticed that smaller stocks are actually outperforming their larger peers in many respects. Here are 10 interesting ways to play this trend.
One of the largest small-cap exchange-traded funds by assets, this fund is benchmarked to the popular Russell 2000 index with about $48 billion under management. The Russell 2000 is formed by ranking the top 3,000 public companies headquartered in the U.S., then excluding the top 1,000 (that group comprises the Russell 1000 large-cap index, if you’re curious). The result is a broad focus on small- and medium-sized companies. Some of the stocks you might recognize, including retailer Five Below (FIVE), but there are others many investors may never discover on their own. The Russell 2000 is up about 10 percent this year, and so is the IWM ETF.
Similar to the Russell methodology, S&P takes the universe of stocks and cuts it into three tranches — the 500 biggest stocks to represent the large-cap S&P 500 index everyone is familiar with, the next No. 501 through 900 to represent the mid-cap S&P 400 index and then stocks 901 through 1,500 to represent the S&P 600 small-cap index. The list overlaps in places with the Russell 2000, but the universe is smaller in total size and generally focuses on companies that are a bit larger.
Instead of listing a large group of smaller stocks, the SLYG layers on a series of growth-oriented screens that cuts the original 600 stocks in this index roughly in half, to take the best growth characteristics. Current holdings include biotech company Ligand Pharmaceuticals (LGND), which soared roughly 80 percent year-to-date, and fast-growing health care billing platform HealthEquity (HQY), which soared roughly 100 percent in 2018. For investors most interested in the growth potential of up-and-coming stocks, this strategy may be just what the doctor ordered.
Not all investors want high-octane small caps. Just as smaller companies can often offer some of the biggest growth potential as they come into their own, under-the-radar value plays are often easier to find in this arena because there is less analyst coverage. Because of a difference in philosophy from the growth-oriented SLYG, the sector makeup is very different in IWN; roughly a third is allocated toward smaller financial stocks, including the southern bank operator IberiaBank Corp. (IBKC). The bias toward financials is noteworthy, but remember that value plays tend to be found in certain sectors more than others.
What if you really like dividend investing, but want to rely more on small-cap stocks? The DES has you covered with a roughly 3.3 percent annual yield — a figure that’s higher than many large-cap funds. But this WisdomTree fund isn’t just a way to higher yield. Its makeup differs significantly from large-cap dividend funds heavy on multinational industrial names like 3M Co. (MMM). Instead, DES has top holdings in consumer discretionary thanks to generous dividends from many retailers, such as GameStop Corp. (GME) and apparel company American Eagle Outfitters (AEO). There are risks tying your dividend to such a cyclical theme, of course, but the trade-off is bigger payouts.
PowerShares S&P Small Cap Low Volatility Portfolio (XSLV)
If volatility and risk are your two bigger fears, then consider the XSLV — a unique twist on small-cap investing designed to weed out the most aggressive names in some of these previous funds. With a focused group of about 600 stocks, this PowerShares ETF applies a screen for each stock and then selects those with the lowest realized volatility over the past 12 months. This is measured against each company’s peer group, smoothing changes from industry to industry. Unsurprisingly, financials and real estate make up a whopping two thirds of the portfolio since these sectors tend to provide the most reliability in the small-cap universe.
If you want to get more tactical, consider a direct play on the consumer discretionary sector via small-cap stocks. That’s what PSCD offers, with names like auto parts firm Monro (MNRO) and casino operator Penn National Gaming (PENN). With consumer confidence metrics at record highs and unemployment at record lows, there are worse ideas than focusing your investments on the smaller companies that depend on U.S. consumers. These cyclical investments may not always be in favor, but they are doing well now with PSCD up almost 20 percent year-to-date to more than double the returns of most major large-cap indexes.
If you really want to go small, then you may want to consider micro-cap stocks. These companies typically trade for less than $1 billion, though the largest stock in this fund’s portfolio of 1,400 holdings is about $2 billion right now via Staar Surgical Co. (STAA) that has roughly tripled so far in 2018. Eventually, companies like Staar grow so much they may be kicked out of this index. But that could be an attractive feature for investors who want to focus on start-ups to ride their growth potential. There is a lot of volatility in individual microcaps, of course, given that they frequently trade on thinner volume.
If you can’t decide on which small-cap fund sounds right, let the more active approach of SMCP take over the thinking for you. This fund changes its holdings based on the subjective approach of its managers. This is in many ways out of step with the typical index fund that is linked to a static list of holdings, but may appeal to investors who have noticed how fast things can change in the small-cap arena. Right now, the fund owns a little more than 30 companies with its biggest bet in security software firm Alarm.com Holding (ALRM), which is up about 50 percent so far this year.
If you’re a true believer in small caps and want outsized performance, this ETF seeks to deliver three times the performance of the Russell 2000 index each day. Since it’s a daily link, there’s not a perfect correlation over the long term. However, the Russell is up about 10 percent this year and the TNA fund is up about 27 percent — so it’s pretty faithful, and plenty generous when things are going your way. Be careful, however, because the inverse is also true: when the Russell 2000 loses 10 percent, you may find yourself three times in the hole.