By Samuel Lee
Micro-cap exchange-traded funds have never been more popular. On
the back of great performance since September, investors have
poured in over $300 million into the four micro-cap exchange-traded
funds, the most ever (see the graph and table below). In doing so,
they are buying some of the worst ETFs on the market today.
I like ETFs. I keep most of my assets in them. However, they're
not suitable for every asset class. Micro-cap ETFs fall prey to
nearly every weakness in the ETF structure, which devastates their
returns. Since inception, the average micro-cap ETF has a monthly
alpha of negative 0.50%, or negative 6.2% annualized. In laymen's
terms, after controlling for the ETFs' risk exposures, such as
size, value and momentum, they trailed their true benchmarks by
about 6% annually.
The average masks a decent amount of variation. The worst is
PowerShares Zacks Micro Cap (
), which clocks in with a negative 7.95% annual alpha. First Trust
Dow Jones Select MicroCap Index (
)'s alpha is negative 2.87%. On the other hand, a well-constructed
ETF like Vanguard Small Cap ETF (
) has zero alpha, as an index fund should.
click to enlarge
The Problem with Micro-Cap ETFs
ETFs work best when their underlying holdings trade in efficient,
deep, and liquid markets. The micro-cap market is none of those.
Micro-caps can go for days, weeks, or months without trading a
single share. Micro-cap ETFs don't venture that deeply into
illiquid shares, but their holdings are often only modestly better.
When they mechanically buy and sell even small share lots into a
relatively illiquid market, they can affect prices. Market impact
costs undoubtedly play a significant role in diminishing micro-cap
Front running also hurts micro-cap ETFs. Indexes are "stupid" in
that they broadcast far in advance when and what they're going to
buy and sell. Clever traders can trade shares in anticipation of
these changes and pocket profits at the expense of indexed money.
Front runners barely budge large-cap indexes such as the S&P
500 because arbitrageurs do a good job keeping stocks in line with
fair value, but they can really hurt micro-cap indexers.
Finally, micro-caps generate much of their outperformance,
thanks to an illiquidity premium. You may be familiar with the
small-cap premium: Since 1926, micro-caps have beaten the largest
U.S. stocks by 6% to 7% annualized. However, the most liquid
small-caps underperform large-cap stocks. The small-cap bonus is
mostly concentrated among the smallest, least liquid issues. So
even if a micro-cap ETF deals with only the most liquid stocks to
avoid price impact and front running, it gives up much of its
Micro-cap ETFs face Scylla and Charybdis: Either lose money to
front runners and price impact while trading illiquid ETFs, or miss
out on the illiquidity premium by holding the more liquid micro-cap
stocks. It's a no-win proposition.
The Mutual Fund Alternatives
Micro-caps can play a role in a portfolio. ETFs just aren't the way
to do it. Micro-cap investors should look at mutual fund offerings,
actively managed or passive. The gold standard for passive funds is
DFA US Micro Cap ((DFSCX)). Over the past five years, its monthly
alpha was a statistically insignificant negative 0.16%. DFA's fund
does everything right: It charges only a 0.52% expense ratio,
returns all share-lending income to investors, keeps turnover low,
trades stealthily, and exploits the latest academic research. DFA
funds are available through a select group of fee-only advisors or
some 401(k) plans.
Bridgeway Ultra-Small Company Market ((BRSIX)) also passively
tracks micro-cap stocks, and since inception it's had monthly alpha
of close to 0%. Bridgeway uses quantitative screens to remove
companies on the verge of going under. However, over the past five
years, the screens hurt its performance, and its alpha was negative
0.39% a month. I'm inclined to give Bridgeway a pass. Unlike the
micro-cap ETFs, which are almost doomed to fail, Bridgeway's
screens have over its 13-year history helped performance and may do
so in the future.
Actively managed funds may offer the best micro-cap
opportunities. Of the 23 micro-cap funds with three years of
history, 22 beat the average micro-cap ETF, despite much higher
Examining VIX ETF Performance During a Sell-Off