August 8, 2014

Is it Worth Investing in Micro Cap ETFs?

Every so often, I'm tempted by the siren song of micro cap ETFs. The smallest investable securities, in theory, may give you outsized returns if you believe in the small cap premium. Recently I came across this old Forbes piece by Rick Ferri from 2010. Based on the CRSP Decile 10 Index, it looks like one would be justified in thinking the smaller the better. 81.7%, holy $#!*! Even the Wilshire Micro Cap Index returned 47.5% that year, smoking small caps to the tune of 10% and nearly doubling the bounce back of large caps after the crash.

Tiny stocks, tiny ponyIf you like to spend your free time playing with Excel, you can have some fun with all of the awesome historical data Ken French as made available here. The "Portfolios Formed on Size" data set includes returns going all the way back to 1926, broken out by deciles, quintiles, and a 30/40/30 split.

On average, the smallest decile appears to be consistently among the highest performers across many time periods.

So how come the available micro cap ETFs didn't hit the 81.7% return in real life? The biggest with almost $900 million assets under management, the iShares Micro-Cap ETF (IWC), returned just 23.7% that year. That's much closer to what large caps did that year. What happened? According to Ferri, most stocks in the micro-cap segment are not investable. With terrible liquidity, these stocks are hard for funds to buy, making it virtually impossible to create a fund that matches a true micro cap index. Many contain a large portion of small caps masquerading as micro cap stocks.

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