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As The Dollar Rises, Look To These Small-Cap ETFs

The rapid surge in the dollar has thus far had little impact on the stock market. But it soon will.

In the upcoming earnings season, you'll be hearing a lot about how many companies in the S&P 500 are having a tough time racking up sales in their foreign subsidiaries. And when you consider that few expect the dollar to pull back any time soon, this trend is likely to persist for at least the rest of 2015.

As we've noted in the past, larger companies tend to have much greater global exposure than smaller companies. And in the face of rising global sales challenges, you would think large cap stocks would be losing favor. Yet the S&P 500 has actually outperformed the Russell 2000 (a small-cap index) over the past 13 months.

The simple explanation: global uncertainty tends to lead to a "flight to quality" as larger companies are generally seen as safer investments. Yet as Q1 earnings season will likely show, these aren't "quality" times for big companies.

That's why I am focusing my research these days on small-cap stocks. A number of individual stocks in the Russell 2000 are now trading far from their 52-week high, even though they have relatively less exposure to foreign sales than their larger counterparts. On a broader level, investors may want to consider exchange-traded funds (ETFs) that focus on small cap stocks. I've been analyzing a dozen of them, and these three are standouts.

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The Vanguards
This is actually a group of four funds: the Vanguard Russell 2000 ETF (Nasdaq: VTWO); the Vanguard Small-Cap Value ETF (NYSE: VBR), the Vanguard Small-Cap Growth ETF (NYSE: VBK) and the Vanguard Small-Cap ETF (NYSE: VB). They all carry ultra-low expense ratios in the 0.09%-to-0.15% range.

Looking at the growth (VBK) and value (VBR) funds, you'll spot some clear distinctions. The typical stock in the growth fund trades for 26 times trailing earnings, according to Morningstar, while the typical stock in the value fund sports a trailing price-to-earnings, or P/E, ratio of around 17.

Over the past five years, the growth fund has delivered a 16% average annual gain, roughly one percentage point better than the value fund. Yet the economic winds are shifting, which may lead to higher volatility across all stocks. As a result, the value fund may be the better choice for the rest of this year, as it has a higher Sharpe Ratio (of 1.46 versus a 1.30 reading for the growth fund).

PowerShares DWA Small-Cap Momentum ETF (NYSE: DWAS)
This fund takes a similar approach to StreetAuthority's Maximum Profit newsletter, written by my colleagues Brad Briggs and Jimmy Butts. This is a "momentum" fund, relying on measures such as relative strength (RS) to identify stocks with the strongest upward price movement. The small-cap fund's approach is paying off lately, leading to a 6.5% gain thus far in 2015, compared to a 4.2% gain for the Russell 2000. It carries a 0.6% expense ratio.

This fund is based on an index created by Dorsey Wright, which tracks the top 200 stocks (out of 3,000) that show the strongest RS. By definition, such an approach will lead to a fund that owns somewhat pricey stocks. The average stock trades for around 40 times trailing earnings. Still, for fans of RS and small caps, this ETF is the best choice.

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WisdomTree Small-Cap Dividend Fund (NYSE: DES)
This fund's name says it all. As you'd suspect, it has more of a growth than a value tilt.

It has built an impressive track record, delivering a roughly 6.5% annualized return since inception in 2006, which is more than a percentage point higher than the Russell 2000 Value Index (6.4%), according to Morningstar. The 0.38% annual expense ratio, of course, eats into some of those returns.

There isn't a lot of stock selection going on here. The fund simply owns all dividend-paying small-cap stocks, with a weighting applied that reflects the size of the total payout in absolute dollar terms.

Small-cap companies have generally lagged their larger peers in their dividend growth strategies, with a number of constituents in the Russell 2000 having only recently begun paying dividends. Yet as more small caps start to become dividend producers, the pool of available stocks that this fund can choose from will steadily expand.

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Risks To Consider: Small caps appear well-positioned in the current economic environment, but would fall out of favor if the economic seas really got rough. They also tend to be more volatile than larger stocks, but that can be either a good thing or bad.

Action To Take--> Studies have shown that small caps tend to outperform large caps over the long haul. That long-term trend has been reversed in recent quarters, making this a good time to give small caps a fresh look. These funds are a good way to gain broad exposure, and depending on your goals, you'll want to study them carefully and find the one that's right for you.

As I mentioned above, the Maximum Profit system is based on stocks with strong upward momentum. It flags exactly which stocks are about to jump double, even triple digits in the coming days, weeks and months. In fact, academic studies have shown that momentum is one of the only indicators that has consistently outperformed the market. So far, the Maximum Profit system is making a small group of investors a lot of money. The system recently tagged a few more stocks that could do the same. To learn more, click here.

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