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Profit from Small Caps with These Value ETFs

Zacks Equity Research

Small caps have been the star performers this year and will likely continue their winning streak even to start 2014. Things are shaping up well in the U.S. market with the Dow and the S&P 500 index hitting multi-year highs day in, day out.

Meanwhile, on December 18, the Fed announced its much-anticipated ‘QE taper’ from January, though by a modest measure of $10 billion per month, leaving monthly purchases worth $75 billion still active.

Nevertheless, the market seems to have taken this taper in stride. Solid data keeps coming in, be it on housing, labor market or manufacturing, are adding further strength to the equity markets. For the week ended December 26, bullish sentiment rose 7.6 points to 55.1% on the expected rise in stock prices over the next six months.

Dominance of Small-Caps

Notably, small cap stocks have played a vital role in carrying this bullish momentum thanks to their excessive domestic exposure. The more the U.S. economy gives out encouraging numbers, the higher will be the surge in small caps. The S&P Small Cap 600 & Russell 2000 index both gained more than 40.0% this year against a 29% rise in the S&P 500 index.

Normally, smaller companies pick up faster than the larger ones in a growing economy. Since these pint-sized securities usually focus more on the domestic market, they get less ruffled by global worries than their globally exposed larger counterparts. This is especially true when a pile of woes might hit a number of developing and emerging nations in the taper-laden 2014 (read: Time for This Top Ranked Small Cap ETF?).

Value Focus is Beneficial

Although small-caps have the potential to offer good returns in a trending market, these are often blamed 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 markets are hovering around lofty levels, many perceive that the U.S. equities as slightly overvalued currently. Amid such a backdrop, value investing will be an intriguing option as this investment paradigm takes into account under-priced securities. These stocks normally have lower P/E, P/B ratios and high dividend yields.

Even though 10-year treasury yields rose from 1.6% in May to the current 3.0% level, yields are still low by historical standards. This fact still keeps value or dividend investing a rising star.

Given this, small-cap value stocks could be excellent choices for investors seeking top picks in today’s market environment. While looking at individual companies is certainly an option, a focus on the basket form could be a less risky way of tapping into the same broad trends (see more ETFs in the Zacks ETF Center).

In order to do this, we have highlighted three top-ranked small-cap value ETFs 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.

This ETF holds about 259 securities in its portfolio and so far has garnered about $78.1 million. The portfolio is well-balanced across the sectors and individual holdings.

No stock occupies more than 1% of the total assets. Consumer Discretionary (19.18%), industrials (18.18%), financials (16.94%) and tech (13.24%) stocks round out the top four.

FYT is also a pricier choice in the space, charging investors 70 basis points a year in fees mainly because of its enhanced methodology. The fund gained about 46% in the YTD time frame.  We currently give FYT a Zacks ETF Rank of 1 or ‘Strong Buy’ rating along with a medium risk outlook.

PowerShares Fundamental Pure Small Value Fund (PXSV)

Launched in March 2005, PXSV is designed to track the performance of the RAFI Fundamental Small Value Index. The fund invests about $61 million of assets in its 752-security portfolio. PXSV adopts equal-weighted approach in case of individual holdings with no single firm making up more than 0.67% of the total.

Only 5.69% focus on the top-10 holdings suggesting extremely low concentration risk. As such, we have a ‘Medium’ risk outlook for PXSV in the near term (see Create a Diversified Portfolio Using ETFs).

The choice charges investors only 0.39% for this exposure which makes it a reasonable one in the space. In terms of sector exposure, financials (22.7%), consumer discretionary (21.83%) and industrials (20.48%) rule the product. 

The fund has returned about 45% so far this year. PXSV pays out a yield of 1.92% per annum and it also carries a Zacks ETF Rank of 1 (Strong Buy).

SmallCap Earnings Fund (EES)

Launched in February 2007, EES looks to track the performance of the WisdomTree SmallCap Earnings Index. The fund is one of the more popular choices in the small-cap value space with about $395 million in AUM. It is a low cost (38 bps) option in the small-cap value ETF space.

Holding 906 stocks in its basket, the product puts less than 10% of its total assets in the top 10 holdings, suggesting minimum concentration risk. Sector wise, this ETF is heavy in financials (23.47%) followed by consumer discretionary (19.44%) and industrials (18.21%).

The fund’s performance this year has been stellar, adding over 45% in the YTD time frame (as of December 26, 2013). EES pays out a yield of 1.25% per annum. The fund carries a ‘medium’ risk outlook along with a Zacks ETF Rank of 1 or ‘Strong Buy’ rating.

Bottom Line

We are looking for a decent level of outperformance for the above-mentioned products over the next few months. Pint-sized stocks with cheaper valuations might steal the show as the economy recovers in 2014, making any of these listed above great picks.

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