If you're trolling the market for a microcap ETF, you're bound to net one of three choices: The PowerShares Zacks Micro Cap Portfolio
Since these funds invest in microcap stocks, they share the risk of that volatile market segment. However, the funds also provide diversification benefits, since the companies composing their portfolios don't move in lockstep with other market capitalizations.
Although these funds all track microcap indexes, each index is created in different ways. FDI tracks the Dow Jones Select MicroCap Index, which selects stocks using market capitalization and trading liquidity screens, along with fundamental screens such as price-to-earnings and price-to-sales ratios, profit change, operating margin, and performance return.
IWC's index, The Russell Microcap Index, includes the smallest 1,000 securities in the small-cap Russell 2000 Index, plus the next 1,000 securities. The fund uses a sampling strategy to match the index, so not every stock in the index is owned.
PZI is tied to The Zacks Micro Cap Index, which is designed to identify companies from the universe of microcap stocks with potentially superior risk-return profiles, as determined by Zacks Investment Research. The index comprises 300 to 500 of the highest-ranking stocks, selected quarterly from among the smallest 2,500 U.S. listed companies by market capitalization, based on a proprietary multifactor quantitative selection methodology. Zacks pitches the index as semi-active.
PZI and FDM have identical expense ratios of 0.5%, while IWC is slightly higher at 0.6%. If you're looking for diversification, IWC has just less than 1,500 stocks in its portfolio, more than three times as many stocks as PZI (with 400) and FDM (with roughly 300). Its large base helps to ensure that IWC's top 10 holdings compose less than 3% of the fund's assets, yet PZI's top 10 holdings account for only 3.6% of assets. FDM's top 10 holdings comprise roughly 5.5% of assets, giving it the potential for more stock-specific risk.
IWC has nearly 25% of its assets invested in financial services, with just more than 16% each in health care, technology, and consumer discretionary. The fund's average market cap is $318 million.
PZI, on the other hand, invests 21.5% of the fund in financial services, while business services and industrial materials each account for just more than 15%. At $299 million, this fund's average market cap is the lowest of the three.
FDM also has a big investment in financial services, at roughly 20%, while cyclical services are a little more than 22%. The fund's average market cap is $495 million, by far the highest of the group.
Although the three ETFs all had inception dates in August or September 2005, their one-year total returns are significantly different. FDM has had the lowest returns so far, at 14.30%; IWC is in the middle, with 17.65%; and PZI was the best of the group, with a 21.82% total return. Of course, this performance record is only for a very short period. At present, there's no telling which fund will be the long-term leader.
As demonstrated by their holdings and returns, these three microcap funds are very different from one another. FDM has the most concentrated holdings and the largest average market cap. PZI has the top returns so far, with one-third more stocks in its portfolio, but the smallest average market cap.
Microcaps are a part of the market rarely followed by most investors, which means there may be potential for good returns. This lack of attention can also mean low liquidity for some companies, and high price volatility. There's also a risk that the individual companies' prices could be artificially boosted by ETFs moving money in and out of them. Microcaps are an interesting area to diversify your portfolio, but don't be small-f foolish about it. I'd advise against putting more than a small portion of your assets in these market minnows.
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Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own shares in any of the funds or companies mentioned in this article. The Motley Fool has a disclosure policy.