Last week’s rally and news of a Spanish banking bailout over the weekend have raised hopes the market is recovering rather than experiencing a dead-cat bounce.
Investors should keep a close eye on microcap ETFs tracking the market’s smallest stocks because they usually lead when traders are embracing risk again.
Microcap stocks are generally viewed as companies with a market capitalization of less than $300 million.
“Historically, they’ve made up less than 2% of total market capitalization,” according to Morningstar analyst Samuel Lee.
Investors should be aware that microcap stocks are subject to high volatility and are extremely vulnerable to downturns – the smaller the capitalization, the riskier the investment but the greater the potential for returns. Their small stature allows them to act nimbly during market rebounds, often jumping ahead of bulkier large-cap stocks at the initial stages of a recovery.
“From 1926 to 2010 they’ve earned about 3% annualized over large caps, a return bonus usually called the ’size premium.’ Investors expect excess return from them because micro-cap stocks are often frail, opaque, and speculative,” Lee added.
Microcap ETFs include:
- First Trust Dow Jones Select MicroCap ETF (FDM - News)
- Guggenheim Wilshire Micro-Cap ETF (WMCR - News)
- iShares Russell Microcap Index Fund (IWC - News)
- Powershares Zacks Micro Cap Portfolio Fund (PZI - News)
It should be noted that ETFs are only as liquid as their underlying assets. Micro-capitalization companies tend to trade at low volumes, which may often move prices against the funds when the ETFs initiate buy or sell positions in their stock constituents, leading to inefficient pricing. [What is an ETF? — Part 13: True Liquidity]
For more information on micro-capitalization market, visit our micro-cap category.
Max Chen contributed to this article.