By Josh Levine
Editor, Levine's MicroCap Investor
When it comes to microcap investing I'm a purist.
I build my MicroCap Investor portfolio carefully one stock at a time with the aim of generating tremendous profits from a relatively small selection of companies developing high-value intellectual property, products and services in biotech, cleantech, emerging IT, and various advanced technologies.
That's my preference. While there are certainly other ways to participate in microcaps, there is one strategy that absolutely makes no sense at all: Microcap ETFs. Money is a terrible thing to waste, and these investments will definitely do just that.
The selling point for microcap ETFs is they offer investors who don't have the time or experience a ready means of participating in microcap investing. But this type of investing is based on a lousy strategy.
Most of the problems have to do with the structure of these little beasts, which are much less liquid than their larger brethren. The best ETFs hold equities that trade in efficient, deep, and liquid markets--everything that microcaps can't provide.
“Microcaps are less liquid than large-cap stocks, and that can lead to wide bid-ask spreads on ETFs that invest in them,” reports Morningstar. “Because ETFs aim to track their benchmarks without concern for the price they pay to execute their trades, they have high trading costs, and that, in turn, has led to poor risk/return profiles for microcap ETFs.”
I'm a fan of using ETFs for sector investing or quick-and-easy hedges on the short side, but for microcaps Morningstar warns that these ETFs are “some of the worst in the world.” They explain that “microcap ETFs fall prey to nearly every weakness in the ETF structure, which devastates their returns.”
Let's be real. Using ETFs to invest in microcaps gives investors the sensation of participating in this market segment. In reality, though, investors are saddled with a large basket of small stocks that underperform even relative to the indexes they're tracking. As Morningstar says, “after controlling for the ETFs' risk exposures, such as size, value and momentum, they trailed their true benchmarks by about 6% annually.”
By now you're probably thinking that microcap mutual funds must offer a much better alternative to ETFs, and they do. Still, putting their exploitive costs aside, most microcap funds invest in 50 to 100 companies and sometimes even more. Unfortunately, this approach dilutes the best strategic advantages of investing in small stocks: focus and leverage.
Further, measuring the one-year performance in three of Morningstar’s top-rated microcap mutual funds against the iShares Russell Microcap Index ETF (IWC), only one of the funds managed to outperform the benchmark.
The truth is that microcaps are not well-suited for passive investors.
For any serious investor who wants to have 5% to 20% exposure to microcaps in his or her portfolio, you've got to be prepared to do your homework because there are no ready-made shortcuts. To take full advantage of the wild inefficiencies and explosive opportunities in the microcap universe, you’ve got to do the research, monitor your investments, and actively manage this portion of your portfolio.