Three Micro-Cap ETFs Worth Considering

Do you remember the childhood wonder of looking at all the colorfully wrapped packages under the Christmas tree, trying to guess what fun was inside? If you were like me, your eyes were drawn to the biggest presents. And if they were too big to wrap, sometimes Santa would just leave them out in the open for us to find in the morning.

After awhile, I figured out that some of the best gifts came in small packages, nestled among the big boxes.

Exchange traded funds (ETFs) are the same way: Sometimes the best funds are unobtrusive, waiting to be noticed and enjoyed.

I’m talking about micro-cap ETFs.

You know that stocks are categorized by their size, or market capitalization (the dollar value of a company’s outstanding shares). Most often you hear about large-cap, mid-cap and small-cap stocks.

Last week I told you about mega-caps, the largest of the large caps. Today we’ll look at the other end of the scale: The smallest of the small-caps. We call them micro-caps.

As with other divisions, the line between small-cap and micro-cap can be fuzzy. Most analysts would peg it somewhere around $300 million to $500 million in market cap.

Any company can slip above or below that line at any time due to market action. Index providers like Dow Jones and Frank Russell compile lists and categorize stocks, making periodic adjustments.

What Can Micro-Caps Do For You?

The dream, of course, is that the stock you pick as a micro-cap grows up and becomes a small-cap, then a mid-cap, and finally a large-cap - multiplying your gains along the way.

When this happens, the rewards can be astronomical - thousands of percentage points! Realistically, though, your chances of picking just the right stock and then holding it all the way up are pretty slim.

This is where ETFs come in … micro-cap ETFs give you broad exposure to the whole category. If only a few of the stocks take off, they’ll pull up the indexes, and your ETF’s value can soar.

With a micro-cap ETF you’re losing some of the upside potential of the individual stocks, but you’re gaining diversification and thus reducing your risk. I think the trade-off is worth it. Plus, when the stock market takes off, micro-cap ETFs have the potential to go much farther and faster than large-cap or even small-cap ETFs.

Three Micro-Cap ETFs Worth Considering …

While several ETFs cover the micro-cap space, iShares Russell Micro-Cap Index Fund (IWC: 39.30 0.00 0.00%) is by far the most popular. With net assets over $300 million, IWC is the most widely-used way to gain diversified exposure to U.S. micro-cap stocks.

IWC tracks the Russell Microcap Index, which consists of 2,000 stocks. These include the bottom of the well-known Russell 2000 Small-Cap index along with 1,000 smaller stocks. IWC omits some of these stocks from its portfolio but still does a good job tracking the index results, especially considering how illiquid some of the component stocks can be.

Currently, IWC holds about half of its assets in three sectors: Financial services, technology, and health care. These sector weightings are similar to the broad stock market.

Two less popular ETFs also cover the micro-cap space.

• First Trust Dow Jones Select Micro-Cap ETF (FDM: 17.8892 0.00 0.00%)
• PowerShares Zacks Micro Cap Portfolio (PZI: 9.81 0.00 0.00%)

Either of these funds can also be a good choice, but IWC is much larger and more liquid.

Be Careful!

There’s a reason micro-caps have so much potential for outsized gains: They also have a big potential for losses. The daily volatility can be enormous. In fact, it’s not unusual to see these stocks swing twice the daily percentage of S&P 500 stocks. So timing your trades can be crucial.

Even though the micro-cap indexes include thousands of stocks, they only make up about three percent of U.S. market’s total capitalization. This makes it easy for unwary investors to become over weighted in these stocks. Therefore, micro-cap ETFs are best used for only a small percentage of your ETF portfolio.

Consider giving them a tiny slice and in time you may get a nice reward.