What Are Small Cap ETF Returns Telling Us?

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Back in April PowerShares came out with its lineup of Small Cap Sector ETFs, making it easier for small-cap investors to play certain sectors of the market. It's a huge deal, and I recommend you pay attention to these funds.

We all know about the Standard and Poor 500, the index is comprised of 500 large-cap stocks that are widely used as a representation of 'the market'. If somebody tells you the average market return over the last 20-years was 7% annually they are probably referring to the S&P 500. Investors who want to buy an ETF that tracks the S&P 500 can easily purchase the SPDR S&P 500 Trust ETF ( SPY ) .

But investors who want to purchase an ETF that tracks just one sector of the S&P 500 can do that too. The ETF company Select Sector SPDRs offers specialized ETFs for each of the nine sectors in the S&P 500. If you were to purchase each ETF in the right proportion, you could emulate a position in the SPY.

Since April, small cap investors have been able to do the same thing by purchasing ETFs designed by PowerShares to track sectors of the S&P Small Cap 600. What these new funds allow us to do is compare the performance of one sector of small-cap stocks with another sector. Equally important, we're able to approximate the performance of small-cap stocks in one sector with large-cap stocks in the same sector. Essentially we have a lot more granularity when it comes to segmenting small-cap stocks.

You'll notice that PowerShares has followed Select SPDRs' ticker convention, but has added the 'S' at the end, presumably to denote small-cap stock. In the table below I've included both, and tried to make it easier to tell the difference by highlighting the large-cap ETFs in light green.

I was interested in checking out the relative performance of small caps and large caps in each of the 9 sectors since June 1 st so I pulled the following data table.

Sector

Ticker

Return 6/1/10 thru 9/24/2010

Consumer Discretionary

XLY

5.7%

XLYS

-3.1%

Consumer Staples

XLP

6.7%

XLPS

4.7%

Energy

XLE

9.4%

XLES

11.4%

Financial

XLF

1.6%

XLFS

1.6%

Healthcare

XLV

7.4%

XLVS

5.3%

Industrials

XLI

8.6%

XLIS

4.0%

Materials

XLB

12.1%

XLBS

-5.1%

Technology

XLK

7.9%

XLKS

5.9%

Utilities

XLU

12.0%

XLUS

11.1%

Entire Index

SPY

6.8%

IJR

3.8%

There was one thing that caught my attention when looking over these returns - out of all nine sectors only one group of small cap stocks has outperformed their large cap brethren since June.

The performance of small cap energy stocks as measured by the XLES is up 11.4 percent versus the large cap energy ETF, XLE, which is up 9.4 percent. Across all other sectors, small caps have lagged the market. Or in the case of financials, there is no difference.

There are a lot of returns here to look at and one can get bogged down in the data. But if you look past the date, the takeaway message runs counter to what we should expect given the state of the economy. Typically, small cap stocks outperform coming out of a recession (remember the recession is now 'officially over').

But these ETFs tell a different story. What's the deal?

I believe there is one major factor. Investors have shunned risk, and that includes small cap stocks. Just look at the paltry yields offered by safe investments like Treasury Bonds, and the fact that investors are still buying them, and it's evident that large numbers of investors remain risk averse.

If and when this changes, I expect to see small cap stocks roar ahead. And if history is any guide, that should be any day now. We are emerging from a recession, and small caps are lagging - it's time investors realize this won't last and get positioned to capitalize on the move.

It's frustrating to wait for the market to catch up with our expectations, but I look at the other side of the coin: we have time to continue to accumulate shares of small cap companies in anticipation of a market recovery. That's good news, especially for those of us who are averaging into positions over a period of weeks and months. It gives us the best possible average buy price.

If you're interested in starting to build a position in a small cap company on the verge of growth, I just picked up another stock on Friday in the Small Cap Investor PRO portfolio. It's no coincidence that this company has exposure to basic materials, a small cap sector that has lagged large caps by 17 percent. If you'd like to learn more, click here .

Where do you think small cap stocks are headed? Let me know your thoughts. My address is: editorial@smallcapinvestor.com .



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: SPY , XLUS

Wyatt Investment Research

Wyatt Investment Research

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