Microcap ETFs: Indexing Leads Investors to Low Returns

The idea of indexing is to produce returns that are good enough; returns equal to a benchmark that fits an investor’s risk tolerance. In most of the investable markets, indexing works perfectly.

Previously, we’ve talked about how indexing does not work so well in less liquid bond markets, with active management producing alpha by avoiding rules-based indexing. It appears that indexing might not work in the microcap segment of the market, either, due to liquidity and front running.

The Many Microcap ETFs

For all the underperformance, every major ETF sponsor has its own microcap fund of some type. Here’s a list of the available microcap ETFs along with a brief description:

1. First Trust Dow Jones Select MicroCap ETF (FDM) – This fund holds 281 different stocks chosen from the two smallest deciles of companies by market cap, liquidity, and the fundamentals on the American public stock markets. The fund comes with an annual expense of .60%.
2. iShares Russell Microcap Index Fund (IWC) – This fund is the most diverse, holding 1000 of the smallest stocks in the Russell 2000 small cap index along with names chosen from the 1000 stocks that follow the 1000 smallest in the Russell 2000 index. The fund currently holds 1331 different names and charges investors .71% per year to own the fund. This is the largest ETF with more than $400 million in assets under management, nearly 10 times larger than the second-biggest rival.
3. Powershares Zacks Micro Cap Portfolio Fund (PZI) – This Powershares fund runs on Zack’s picks in the microcap segment of the public markets. The 400 or so stocks Zack’s believes will outperform are included, and investors are charged .60% per year to own this fund. So far, the fund has failed to beat its benchmark, which doesn’t bode well for Zack’s selection criteria.
4. Wilshire Micro-Cap ETF (WMCR) – This fund is built on the back the Wilshire 5000 index, grabbing some of the smallest 2500 stocks in the index and adjusting for the public float and market cap weighting each position. The fund currently holds 865 positions and charges the lowest fee of any microcap fund at .5% per year.

What’s Wrong with Microcap ETFs?

The primary problem with microcap indexes is liquidity. Illiquid microcaps are very much like illiquid bonds. When an index has to buy or sell a stock to rebalance for its rules, it arbitrarily enters trades at the market price, often driving up or down the price of the security with no respect for the company’s true intrinsic value. This leads to rampant front-running by smaller investors and active managers. What works in highly-liquid stocks such as those in the S&P 500 index (SPY) does not work in low liquidity microcaps.

Active microcap managers are generating alpha. Some funds with a 5-year track record for alpha generation by active managers in the small cap market include funds like Catalyst Value A Shares (CTVAX), Wasatch Micro Cap (WMICX), and Perritt MicroCap Opportunities (PRCGX). Notice: these funds are all actively-managed mutual funds, not index exchange-traded funds. There are, of course, several underperforming active managers in the microcap space as well.

Fees tend to be significantly higher as fund sizes are substantially smaller than small, mid, and large cap funds.

Investors who want exposure to small cap investments have much better opportunities at much lower expense ratios. The popular Russell 2000 small cap index has two different ETFs tracking it, while iShares’ Small Cap 600 Index ETF (IJR) offers excellent small cap exposure at a lower price than microcap ETFs.  Along the same lines, if minimizing costs is your focus, here are the 5 lowest cost ETFs on Earth.

Bottom line: Microcaps are simply too small, too illiquid, and too risky to track with an index. Investors would be better off to index to slightly larger small caps, getting all the benefits of higher beta and higher returns in the long haul with less liquidity risk and lower annual expense ratios.

Disclosure: No position in any tickers mentioned here.