3 Top Small-Cap ETFs To Buy Now
The much anticipated Fed interest rate cuts have arrived, kicking off the season with a 50 basis point reduction. An additional half-percentage point reduction is likely before the end of the year and an additional percentage-point cut in 2025. Experts project a great rotation into small-cap stocks amid the easing in the interest rate environment, as small-cap stocks typically tend to benefit most from an interest rate cut. However, small-cap stocks are more prone to volatility and carry high risk-reward characteristics, and to pick a few from the haystack requires meticulous due diligence. Small-cap exchange-traded funds (ETFs) present a cost-effective opportunity for investors looking to tap into this dynamic and fast-growth segment of the market. Through diversification, ETFs help to mitigate risks often associated with investing in individual stocks. Yet, this asset class is not risk-proof either.
Understanding Small-Cap ETFs
Small-cap ETFs tracking indexes like the Russell 2000 or S&P 600 small-cap index are passive funds, aiming to replicate the performance of the underlying index. The Russell 2000 index includes nearly 2,000 small-caps, but the S&P 600 index is more qualitative as it screens for stocks with positive (as-reported) earnings for the most recent quarter, as well as for the most recent four quarters (summed together). Stringent requirements for member inclusion has led to the superior performance of the S&P 600, which consistently beats the Russell 2000. While it’s not possible to directly buy or sell an index, index-tracking ETFs offer opportunities to trade the indices and are designed to offer the equivalent of market returns. Small-cap ETFs are more risky vs. other ETFs, because of the volatility of the underlying securities.
Although ETFs are typically synonymous with passively-managed index funds, actively managed ETFs are on the rise. Actively managed ETFs are more expensive than index-tracking ETFs but also have the potential to deliver market-beating returns. According to a Morningstar report, there are 2,149 index-tracking ETFs and 1,619 active ETFs as of September 10, but the gap is significantly narrowing as more active ETFs are getting listed on the U.S. exchanges (with 418 listings in 2023 and 331 so far this year). Just for more clarity, active ETFs have a lot of catching up to do, because this asset class still represents less than 8% of the $9.5 trillion of total investments in ETFs.
The Avantis US Small Cap Value ETF
AVUV
is an example of an actively managed small-cap ETF with more than $12 billion in assets. AVUV includes members with high profitability and value characteristics. The ETF has returned 25% in the past year, vs. the 17.1% returns of the small value category.
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How These Small Cap ETFs Were Chosen
To pick the small-cap ETFs, the criteria was to identify category outperformers in the shorter and longer terms with adequate assets, offering a mix of passive and active management, and a blend of small-cap growth and value.
Selection criteria;
- The ETFs had to be category outperformers in the year-to-date, one-year and three-year periods. (shorter and longer time periods)
- Net assets of at least $750 million
- Expense ratio under 0.50%
- To include at least one actively managed ETF
- To include passive ETFs tracking the S&P Small cap 600’s growth and value segments
3 Top Small Cap ETFs To Buy Now
Data source: Yahoo Finance
1. Invesco S&P SmallCap Momentum ETF
XSMO
Fund Overview
Invesco S&P SmallCap Momentum ETF tracks the S&P SmallCap 600 Momentum Index, which is composed of 120 securities from the S&P SmallCap 600 Index with the highest momentum scores (meaning U.S. small-cap stocks that exhibit strong price momentum.) XSMO deploys a “full replication” methodology in seeking to track the underlying index, meaning that it generally invests in all of the securities comprising the S&P SmallCap 600 Momentum Index in proportion to their weightings. The fund and the index are rebalanced and reconstituted semi-annually. The fund has 115 holdings with the top 10 holdings representing 22.6% of total assets. Industrials dominate XSMO’s sector weightings, with a 29% representation.
Why Is XSMO A Top Choice?
XSMO is a good way to get exposure to small-cap growth, as the ETF tracks fast-growing quality stocks with strong price momentum. XSMO has outperformed the small-growth category in the year-to-date (16.7% return vs. 11.2%), 1-year (35.6% vs. 16.2%) and 3-year (9.6% vs. negative 3%) periods. Despite the outperformance, XSMO trades at a price-to-earnings (P/E) ratio of 9.73 vs. its peers’ 11.45. The attractive valuation, growth potential and rate cut tailwinds should likely support XSMO’s performance going forward, although past performance is not an indicator of future performance. It also pays an annual dividend of $0.30 with a forward yield of 0.5%.
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2. Invesco S&P SmallCap 600 Revenue ETF
RWJ
Fund Overview
The Invesco S&P SmallCap 600 Revenue ETF tracks the S&P SmallCap 600 Revenue-Weighted Index that weighs the members of the S&P Smallcap 600 based on their positive revenues with the weighting per company capped at 5%. RWJ uses a full replication technique to track the S&P SmallCap 600 Revenue-Weighted Index, which is rebalanced in March, June, September and December. RWJ is 18.8% concentrated in its top 10 holdings. The consumer cyclicals sector representing companies that make discretionary goods, including vehicles and entertainment products, represents 23.3% of RWJ’s portfolio.
Why Is RWJ A Top Choice?
RWJ presents an effective means of accessing small-cap value, as its revenue-weighted methodology has the potential to drive long-term value creation. RWJ has outperformed its category (which is small value) in the year-to-date period (10.7% vs. 8.5%), one-year period (24.3% vs. 17.1%), and three-year period (8% vs. 5.8%). It also pays an annual dividend of $0.55 with a forward yield of 1.2%.
3. Principal U.S. Small-Cap ETF
PSC
Fund Overview
The Principal U.S. Small-Cap ETF is actively managed and tracks small-cap stocks with attractive quality, momentum and value, while avoiding stocks of fundamentally distressed companies. It caps exposure to a single security at around 0.7% to maximize diversification benefits with top 10 holdings of PSC representing only 6.9% of total assets. PSC favors more liquid and less volatile securities and seeks to be sector neutral. Financial services represent the largest sector at 17.1% weighting, closely followed by Healthcare at 16.8%, Technology at 15.5% and Industrials at 15.3%.
Why Is PSC A Top Choice?
PSC enjoys the benefits of professional management for navigating dynamic shifts in the market. The ETF also offers exposure to a blend of small-cap growth and value segments and diversification benefits, while avoiding distressed companies by deselecting the bottom decile of the Russell 2000 index as part of its liquidity screening. PSC has outperformed its category (which is a blend of small growth and value) in the year-to-date (12.8% vs. 10.2%), 1-year (26.4% vs. 17.6% ) and 3-year (6.9% vs. 3.3%) periods. PSC has also outperformed the Russell 2000 in the last three years. It offers an annual dividend of $0.39 yielding 0.8% on a forward basis.
Tips For Successful Investing In Small-Cap ETFs
- My preference is an ETF tracking the S&P 600 index that adheres to strict rules for index inclusion vs. the larger and more relaxed Russell 2000, unless the ETF is actively managed.
- Research the ETF and check the portfolio to understand which companies are included. Try to avoid any ETFs that include troubled/distressed companies, and more volatile and less liquid components.
- Check to ensure that the ETF is not heavily concentrated on a single sector and there is enough diversification to mitigate sector concentration risks.
- Look for lower expense ratios to keep the costs down, but don’t make it a limiting factor, as higher returns more than justify the expenses in some cases. So, exercise discretion based on your risk tolerance.
- Check the performance history of the small-cap ETF for the year-to-date, 1-year and 3-year periods. Although past performance is no guarantee for future returns, it can be a key data point for investment consideration.
- Stay on top of market trends, economic indicators and macro factors that can impact the small-cap stock segment.
- Keep up with company developments of at least the top 10 holdings of the ETF to assess any potential impact on performance.
- Small-cap securities are more sensitive to economic changes and susceptible to volatility. So, don’t put all your eggs in the small-cap basket. A well-balanced portfolio is a must and it is good to regularly review and rebalance your portfolio.
- Seek professional guidance if you must. It may cost more, but potentially solid returns may likely compensate for higher expenses.
Bottom Line
Fed rate cut tailwinds are likely to fuel a resurgence in the small-cap segment. The best way to circumvent the risks and volatility typically associated with the small-cap stock sector is to invest via small–cap ETFs that offer a cost-effective, low risk opportunity with diversification benefits vs. investing in individual stocks. The XSMO, RWJ and PSC ETFs highlighted here are category outperformers in the shorter and longer terms with adequate assets, and offer a mix of passive and active management, as well as exposure to a blend of small-cap growth and value.
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