Stock research can consume a tremendous amount of time. That’s especially the case with microcaps, which often include companies with little-to-no financial information in the public domain. Microcaps traded OTC also receive far less regulatory scrutiny compared to companies listing on the major exchanges.
Yet the opportunities in penny stocks exist, and some investors still make a killing off trading in microcaps. They understand the companies they invest in. They realize when news affecting a company or entire sector means it’s time to make a move.
But there’s that gnawing time commitment required to make wise decisions.
You can utilize quant trading and let algorithms figure out the opportunities. You can spend your time researching individual companies, their financials and reading analyst reports. But the day may come when it’s worth considering unloading some of this essential work. Microcap ETF managers do the heavy lifting, usually for a nominal fee.
One benefit of investing in an ETF is portfolio transparency. There is no mystery as to where your dollars are being invested. For most funds, just click the ETF’s prospectus and select “Holdings & Reports” to review the most recent daily holdings. These stocks are typically listed as of the most recent month-end.
ETFs tend to be less volatile than individual stocks, meaning an investment won’t swing in value as much. The best ETFs have low expense ratios, the fund’s cost as a percentage of the investment. The best may charge only a few dollars annually for every $10,000 invested.
First, take a look at the performance of the Russell 2000, a market index of small cap stocks. The Russell 2000 is observing its 40th anniversary this year. While the index has seen two recent flat years, over the last decade it has outperformed the Dow and is competitive with the S&P 500.
On the down side, nearly half the companies in the Russell 2000 are unprofitable. Investors in a microcap ETF are paying the managers to separate the wheat from all the chaff.
Investors typically share a common goal: achieving alpha — outperforming the market and generating excess returns. With the explosion of interest in microcaps to achieve this goal, scores of small-cap ETFs have emerged.
ETFs encompass a diversified mix of investments, offering fractional ownership of underlying assets. Acquiring ETF shares is not unlike buying stocks, providing ease of access and many choices.
Stocks, of course, represent ownership in a single company, while ETFs pool together assets from multiple entities, offering greater diversification and potentially lower risk. Picking individual stocks may yield higher returns, although these potential rewards come with greater risk along with the effort required for research and management.
Pros and cons of picking individual stocks:
- Higher potential returns, especially with growing companies.
- Commission-free trading options.
- Direct control over investments.
- Higher risk due to dependence on a single company’s performance.
- Requires significant research and monitoring.
Pros and cons of ETFs:
- Enhanced diversification across multiple assets.
- Reduced risk through broader exposure.
- Convenient trading similar to stocks.
- Limited control over specific investments.
- Potential underperformance compared to individual stocks.
- Management fees impacting total returns.
ETFs share an advantage similar to hedge funds: one bad investment is not going to torpedo the entire ship. Better still, ETFs don’t charge the exhorbitant fees levied by hedge funds, which are typically accessible only to the uber-wealthy.
Largest Microcap ETFs
There are literally dozens to choose from. These are the largest.
1. iShares Microcap ETF (IWC) issued by Blackrock is one of the largest microcap ETFs.
2. First Trust Dow Jones Select MicroCap Index Fund (FDM) managed by First Trust Advisors— as the name suggests, is a microcap ETF that tracks the performance of the Dow Jones Select MicroCap Index.
3. Invesco DWA SmallCap Momentum ETF (DWAS) tracks the Dorsey Wright SmallCap Technical Leaders Index, which invests in a mix of small-cap and microcap stocks. Companies are also chosen for their relative strength in stock price momentum.
Successful microcap investing demands continuous market analysis and in-depth knowledge. Alternatively, ETFs offer simplicity and diversification, making them attractive to investors seeking a hands-off approach or risk mitigation.
Ultimately, the choice between stocks and ETFs depends on individual preferences and investment goals. Combining stocks and ETFs can easily improve portfolio diversification without nearly as much research involved in picking individual securities. A blend of both can also help tailor an investment strategy to satisfy objectives and risk tolerance.
DealFlow Events makes no recommendations on whether to buy, sell or hold shares of any particular stock. Investors are advised to conduct their own research and analysis before making an investment decision. Neither DealFlow Events nor any of its affiliates hold any position in the stocks mentioned in The Microcap Newsletter.