4 Ways to Capture the Big Opportunities in Small Stocks
By Ron DeLegge, Editor
May 4, 2009

SAN DIEGO (ETFguide.com) – Finding the next Apple or Microsoft is like looking for a needle in a haystack. And even though most people will never find either, none of it keeps them from trying. 

Take for example, America’s mutual fund managers. They’re charged with the responsibility of discovering tomorrow’s blue chip stocks. Yet, according to Standard & Poor’s research, over the past five years an astonishing 79.1% and 85.8% of mid and small company stock funds were outperformed by dull mid and small cap stock indexes. Put another way, professional money managers have been buying the wrong stocks!

What about individual investors? It seems like they too are having difficulty in making the right investment decisions.

In its 15th annual survey of investor behavior Dalbar found that 58% of investors bought and sold their investments at the wrong time last year. As a result, many of these same investors experienced substantially worse performance of their investments compared to stock index funds.

The mistake of buying the wrong stocks could’ve easily been avoided if investors just trusted in the indexes and the financial products following them instead of the fund managers that try to beat them and fail.

Let’s evaluate 4 exchange-traded funds or ETFs that can help you to capture the big opportunities in small stocks.

iShares Russell 2000 Index Fund (NYSEArca: IWM)
IWM is benchmarked to the widely followed Russell 2000 Small Cap Stock Index. It contains around 2,000 U.S. stocks with market sizes between $250 million to $3 billion. The index represents the smallest companies within the broader Russell 3000, which aims to measure the performance and yield of the total U.S. stock market.

Myriad Genetics (0.47%), Ralcorp Holdings (0.45%) and Sybase (0.37%) are among the IWM’s top three holdings. In 2008, IWM fell 33.65% but so far this year it’s down just 0.52%. Financial services (20.84%) and consumer discretionary (17.29%) are currently the two largest industry sectors within IWM. The fund’s annual expense ratio is 0.20%.

SPDR Dow Jones Small Cap ETF (NYSEArca: DSC)
DSC follows the Dow Jones U.S. Small Cap Total Stock Market Index. Even though Dow Jones has eliminated this particular fund’s former name (DJ Wilshire Small Cap Index), its strategy remains unchanged. The index represents the small cap portion of the Dow Jones U.S. Total Stock Market Index. Components are ranked from 751-2500 by full market capitalization. The index is float-adjusted market capitalization weighted and additions to the index are made once a year in June.

In 2008, DSC declined by 37.47% but so far this year it’s risen nicely by 5.52%. DSC’s annual expense ratio is 0.25%.

Vanguard Extended Market ETF (NYSEArca: VXF)
This particular Vanguard ETF shadows the S&P Completion Index (SPCMI). The SPCMI is a subset of the S&P Total Market Index of approximately 4,500 companies, less S&P 500 stocks. Companies are removed from the index as they are placed into the S&P 500.VXF holds approximately 3,200 of the roughly 4,000 companies in the SPCMI.

In 2008, VXF declined 38.59% but so far in 2009 it’s risen by 4.09%. VXF’s annual expense ratio is a rock bottom 0.08%.

WisdomTree Small Cap Dividend Fund (NYSEArca: DES)
Most small company stocks don’t pay significant dividends. That’s because tiny companies tend to plow profits back into growing their businesses rather than distributing profits to shareholders via dividend payments. However, DES screens for small companies that pay dividends and then weights within its underlying index according to their proportionate cash dividends paid. At the end of March, the fund’s dividend yield was 7.7%.

In 2008, DES did better than traditional small cap indexes by declining just 27.63%. However, because of its 44.62% exposure to financial services stocks, DES has lagged this year, falling by 9.26%. The fund’s annual expense ratio is 0.38%

Finding Tomorrow’s Winners
The greatest opportunity for future capital growth resides with mid and small company stocks. These are young companies involved in innovative industries that will reshape the corporate landscape. Generally, mid cap stocks have market sizes between $2 billion to $10 billion. Small cap stocks typically have market sizes between $250 million and $2 billion.

Contrary to what you may have been told, you don’t need mutual fund managers to help you find tomorrow’s great stocks. Mid and small cap ETFs in most cases will outperform their stock picks and even your own selections! If you’re still not convinced that ETFs can do better, try investing in one and then benchmark the performance of the corresponding active fund you would’ve bought versus your ETF. This exercise will help you to avoid the market underperformance experienced by millions of mutual fund investors.  

Evaluating your Portfolio
Do you have market exposure to small companies within your investment portfolio? Mid and small company stocks have been outperforming large stocks so far in 2009. The S&P MidCap 400 (NYSEArca: MDY) is up 4.42% and the S&P SmallCap 600 (NYSEArca: IJR) is down 1.5% compared to a 1.91% decline for the S&P 500 (NYSArca: SPY).

And there’s one last benefit of going the ETF route to discovering tomorrow’s winners.

Mid and small cap ETFs can save you the headache of market underperformance along with the supreme difficulty in locating tomorrow’s Apple’s or Microsoft’s. In the May issue of the ETF Profit Strategy Newsletter, we assembled a list of the top 50 MidCap stocks and matched up their corresponding ETF replacements. If you own any of the mid cap stocks on our list, we’ve identified the right ETFs that can help you to reach your financial goals. Check it out.