Small Cap ETFs: Everything you need to know

Small Cap ETFs are one of the simple high-growth investment options for investors. When it comes to investing, we find different sizes of companies depending on their market capitalisation, and this often means that they have some characteristics that differentiate them from the rest.

The Small Caps, which are low capitalisation companies, are considered a market where there are more inefficiencies that investors could exploit. This is because in theory fewer analysts and individual investors follow them and, therefore, the discovery of prices and discounting of expectations is slower and less efficient.

In this article, we will see what Small Caps are, what the Small Caps factor is, and the best small cap ETFs to invest in.

small cap value etf

What are Small Caps and why are they interesting to invest in?

When we talk about Small Caps we refer to those companies that have a smaller market capitalisation. This would be roughly between £50m and £230m(London Stock Exchange) depending on the index provider.

Many indices follow this type of company. The two most known are the Russell 2000 and the S&P SmallCap 600. But despite having the same objective of following low capitalisation companies, their composition and requirements are different, and therefore, their returns:

top small cap etfs

For this reason, we must choose the ETF well in which we are going to invest and review the composition of its index and exposures.

The biggest difference between the Russell 2000 and the S&P 500 index, is that the second uses a profit filter, that is, the selected companies must have a history of positive earnings to be eligible.

Small Caps as a Factor

In the '90s, professors Fama and French created a 3-factor model to expand the famous CAPM.

Apart from the market risk (beta), they added two other risks: size or small cap (represented by market capitalisation) and Value (represented by low multiples).

These two risks, also commonly called factors, would be the first two on a long list of others that would be discovered later and about which we will be writing.

They are responsible for explaining returns above the average in certain portfolios or exposures.

Requirements and Nuances of Investing with the Small Caps Factor

Everything in this life has a price and more so in the Stock Market, it is for this reason that the above-average return that factors like small caps give, comes with certain important nuances and limitations when applying it in real life.

Factor investing in general has 3 basic requirements:

  1. Assemble a broad portfolio in terms of the number of shares and concentrate on the factor so that its alpha is not lost.
  2. Rebalance the portfolio periodically to remove those that no longer meet the best factor rating and add or keep the companies that do meet it.
  3. Repeat this process for many years because although the chances of success are high, we can always fall into the years of failure probability and if we abandon the strategy here we might not be in when it has the recovery that will compensate for those bad periods.

Now let's go with the nuances that are also very important:

The first nuance is volatility.

-Although we know that volatility and risk are different things, it should be clarified that small caps have higher volatility than the average and much more than most large-cap companies. Therefore, before investing based on this factor we must be comfortable with the greater variations it will have, with the maximum drawdown and with the waiting time to recover.

The second nuance has to do with the risk of subsequent returns and how stuck the strategy can become

-This would mean that the pie is shared among more and, therefore, the returns decrease.

The third and final nuance has a lot to do with the requirement of building a broad portfolio

But focused on the factor. That is, we must have all the shares that correspond to the percentile or even the decile of lower capitalisation for this small cap factor.

The nuance refers to the fact that many times investors and managers fall into the bias of representativeness and the ergodic fallacy and think that the high probability of good returns from a broad portfolio focused on the small caps factor is also automatically transferable to the individual selection of shares within a portfolio that is not so broad. That's why we see so many active management small cap funds that don't beat their indices.

How to invest in the Small cap ETFs?

ETFs are characterized by providing cheap and fast access to very specific markets such as the Small Caps indices in this case, and we can find them for different countries and regions.

The advantage of investing in small cap ETFs is that they already do all this heavy work of selecting the values, building the portfolio and rebalancing it. But as we saw in the example of the indices, sometimes they don't do it in the best way. That's why each of us has to see what its composition is and select the one that is most in tune with our strategy and objectives.

The following is a list of small cap ETFs that can be purchased in Europe and that follow the Smallcaps factor.

Best Small Cap ETFs to Invest in

In the following table, you can find a compilation of Small Cap ETFs with the best accumulated return in the last 3 years.




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Best growth ETF to invest in

Best technological ETFs to invest


Something quite curious and that again gives an example, not only of the market cyclicality but also of the need to be diversified, is that even though emerging markets have performed poorly if we look at the MSCI Emerging index, the subset of emerging small caps has performed well.

In the following image, we can see the comparison of the performance of the prices (Without dividends) of the emerging ETFs mentioned above against the EIMI which is an ETF that follows the MSCI Emerging and includes dividends. I know many will tell me that the comparison is incorrect, because some do not include dividends and others do, but I have done it this way so that we see that even with dividends, the EIMI has not been able to approach the others.

best small-cap energy etfs

Analysis of SPDR MSCI USA Small Cap Value Weighted UCITS ETF

The ETF follows the MSCI USA Small Cap Value Weighted index which has in its portfolio small capitalisation companies from the US weighted by sales, profits, cash and book value.

It follows an optimized sampling physical replica. Its base currency is the USD and it does not have currency coverage. It is domiciled in Ireland and its dividend policy is accumulation.

These are the main positions of your portfolio:

quality small caps

And this is a sector breakdown:

small companies to invest in

WisdomTree Emerging Markets SmallCap Dividend UCITS ETF

The ETF follows the WisdomTree Emerging Markets SmallCap Dividend index which tracks small-cap companies with high dividends in emerging markets and filtered by ESG criteria. It is weighted by fundamentals.

Its method of replication is physical, with optimized sampling. Its base currency is the USD and it does not have currency hedging. It is domiciled in Ireland and its dividend policy is semi-annual distribution.

The following is a breakdown of its portfolio with the main positions, weights by sector and geographical distribution:

Small Cap ETFs UK

Analysis of SPDR MSCI Emerging Markets Small Cap UCITS ETF

The ETF replicates the MSCI Emerging Markets Small Cap index which seeks to track small-cap companies in emerging markets.

It has an optimized sampling physical replication. Its base currency is the USD and it does not have currency hedging. It is domiciled in Ireland and its dividend policy is accumulation.

The following is a sector breakdown of its portfolio:

small cap index

These are the weights by country:

Small Cap ETFs

These are its main positions:

Small Cap ETFs

Remember that ETFs are not bought by fund marketers but by brokers.

Conclusions

As I have already mentioned before, it is the Strategy that will tell us which small cap ETFs we should buy, when to buy it and when to sell them.

The Small Caps ETFs can be a good alternative for those who want to have exposure to this factor. They are usually suggested as tilts or biases for the core of a passive indexed portfolio, but they could also be part of other types of portfolios, and there are even passive indexed portfolios that use this factor as a core.

You just have to review well the index they follow, the nuances and requirements so that everything is in tune with your portfolio. Also make sure you are using the best trading platform for ETFs, that matches with your investing plan.

FAQs

What is market capitalisation?

It refers to the value of all outstanding shares multiplied by the price per share. It is a value that is used to say how much a company is worth, but it should not be confused with its intrinsic value.

What are small cap stocks?

They are usually companies that have a capitalisation between £50m and £230m, but that level can vary a bit depending on the index provider.

How to invest in small caps?

In the article, we mention some ETFs to invest in smallcap companies, but it can also be done through investment funds or by individually selecting companies within the universe of small caps.

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