Time for This Small Cap Value ETF?

As the economic indicators suggest, 2014 would be a banner year for developed nations with the U.S. being the frontrunner. Though, after a tepid start in 2014, the U.S. market rebounded as soon as the chilly winter passed into spring.

If a better job market, reassuring earnings picture, improving manufacturing numbers and decent home sales data were not enough to assure investors about steady economic growth, the persistent axe on QE stimulus is also giving cues.

However, the situation is not so favorable in the global market with escalating geopolitical tension pertaining to the Russian-Ukraine issue slowly spreading into other nations. Emerging markets will also be highly fragile this year thanks to their intense vulnerability to hot money flows from the Fed’s QE program.

A slowdown in the world’s second largest economy is another cause of concern. Amid such a situation, what could be a better option to play the revival in the US than small-cap ETFs?

Small Caps in Focus

In short, the more the U.S. economy gives out encouraging numbers, the higher will be the surge in small caps as this capitalization level mainly focuses on the domestic economy. With some global issues emerging all of a sudden, small caps have once again taken the front seat (read: Time to Focus on Small Cap ETFs?).

Although small-caps have the potential to outperform in a trending market, these are often held responsible for increasing volatility. Thus, investors seeking equity appreciation with a lower level of risk should look for value in the small-cap space.

As the stock market indices have reached record high levels this year, many perceive the U.S. equities as slightly overvalued currently. This is truer in the context where small cap stocks played a vital role in the market momentum last year.

In such a backdrop, value investing style seems compelling as this investment paradigm boils down to picking up under-priced securities. These stocks normally have lower P/E, P/B ratios and high dividend yields (read: 3 Small Cap Value ETFs Poised to Outperform).

Given this bullish trend, a look at some of the top ranked ETFs in the space could be a good way to target the best of the segment. In order to do this, investors can look at the Zacks ETF Rank and find the top small-cap value ETF.

About the Zacks ETF Rank

The Zacks ETF Rank provides a recommendation for the ETF in the context of our outlook for the underlying industry, sector, style box or asset class (Read: Zacks ETF Rank Guide). Our proprietary methodology also takes into account the risk preferences of investors. ETFs are ranked on a scale of 1 (Strong Buy) to 5 (Strong Sell) while they also receive one of three risk ratings, namely Low, Medium or High.

The aim of our models is to select the best ETFs within each risk category. We assign each ETF one of five ranks within each risk bucket. Thus, the Zacks ETF Rank reflects the expected return of an ETF relative to other products with a similar level of risk.

For investors seeking to apply this methodology to their portfolio in the small-cap value space, we have taken a closer look at the top ranked FYT. This ETF has a Zacks ETF Rank of 1 or ‘Strong Buy’ (see the full list of top ranked ETFs) and is detailed below:

First Trust Small Cap Value AlphaDEX (FYT)

This fund looks to have an enhanced exposure to the Defined Small Cap Value Index. The index uses the AlphaDEX methodology to select stocks from the S&P SmallCap 600 Value Index. Stocks are screened on the criteria of higher price appreciation, sales to price and one-year sales growth, book value to price ratio, cash flow to price ratio and return on assets.

It ranks the stocks in the space by various growth and value factors, eliminating the bottom ranked 25% of the stocks. As such, FYT should generate positive alpha relative to traditional passive indices since it uses AlphaDEX methodology and allots higher weights to more favorably ranked firms.

This ETF invests about $81 million of assets in 247 securities. The portfolio is well balanced across the sectors and individual holdings. No stock occupies more than 1.02% of the total assets. Its top three holdings include Green Plains Renewable Energy, Helen of Troy Limited and Engility Holdings.

As far as sector exposure is concerned, Consumer Discretionary (18.98%), Information Technology (16.41%), Industrials (15.92%) and Financials (15.62%) stocks round off the top four (also see 3 Ultra Cheap ETFs for Value Investors).

The fund charges 70 basis points in annual fees for this quality exposure which is costly for the space. The fund gained about 2.07% in the YTD time frame in contrast to 2.42% gain seen in the biggest fund in the space – iShares Russell 2000 Value Index Fund (IWN).

Over the past one year, FYT’s ascent of 31.94% was well ahead of the 23.34% advancement in the broader market fund SPDR S&P 500 ETF (SPY). We currently give FYT a Zacks ETF Rank of 1 or ‘Strong Buy’ rating along with a medium risk outlook.



Bottom Line

In a nutshell, though U.S. stocks across the capitalization should surge this year as the economy gains pace, as of now, small-caps would be wiser bets. This way, investors can get the real picture of U.S. resurgence. Those afraid of the volatility quotient in this capitalization type, can consider investing in the aforementioned small-cap value ETF as a potentially lower risk way to play the space.

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