Small Cap ETFs: Five reasons to invest in small-cap companies

Nov 10th, 2011 | By | Category: Equities

With all the drama and uncertainty surrounding the eurozone debt crisis, investors have been shifting out of small cap companies and into large caps in the belief that these offer a safer bet. While this tactical shift is understandable, investors are potentially overlooking a number of highly attractive features unique to small caps.

Five reasons to buy small cap ETFs

Small cap companies look well positioned to weather further turmoil and set to rally once once dangers recede.

First, numerous studies have shown that small caps tend to outperform over the long term. Indeed, a study by Choi and Mukerji of Brown University made a very strong case for investing in small cap companies. Their study looked at 10-year returns to each month end from 1926 to 2007 for a number of different asset classes. The cumulative results showed that small caps had the highest returns.

Other studies point to similar conclusions. Professor Kenneth French, famous for his work with Eugene Fama on asset pricing, demonstrated conclusively that US small caps outperformed large caps in the period 1927 to 2009. And research by Ibbotson Associates, an investment consultancy, showed that for the 71-year period from 1926 to 1997 US small cap value stocks, in particular, outperformed the general market by a substantial 4.3% annually.

Moreover, the outperformance of small caps isn’t just a US phenomenon – the same trend holds true across a wide variety of global equity markets. Of these studies, however, perhaps the most interesting discovery was that, on average, the long-term expected volatility for small cap companies was broadly in line with that of large caps, thus challenging the notion that small caps are more volatile.

Second, small cap indices tend to be more diversified and less dominated by individual companies or specific industry groups. The top ten stocks in the Euro Stoxx Small Index, for example, equate to 16% of the index, whereas the top ten stocks in the Euro Stoxx 50 Index of large cap stocks equate to a whopping 39%.

Third, it is easier for small cap companies to grow. While large caps might offer greater stability and predictability of revenues, their ability to grow rapidly is restricted by their cumbersome size. Small cap companies, however, are nimble and more likely to harbour the entrepreneurial talent that can be the source of disruptive, game-changing and highly profitable technologies. In short, they have the potential to become large cap in the future.

Fourth, small caps are more likely to be the subject of takeover bids. For large companies wishing to increase sales or expand into a new region or sector, a quick fix solution is to simply buy up a smaller player. Similarly, rather than splash out vast sums on research and development, it’s often easier to bid for a smaller rival – as is common practice in the pharmaceutical and technology sectors.

On this point, it’s worth highlighting that the current environment of expansionary monetary policy suggests that we will see a significant up-tick in takeover activity once the immediate dangers of the eurozone crisis pass. Having cut costs and preserved cash, large cap companies are now sitting on huge piles of cash. By one account, major non-financial US companies are believed to hold around $1.24 trillion in cash on their balances sheets, while Stoxx Europe 600 Index companies are estimated to hold $690 billion. If these companies start to unload their cash by acquiring small cap companies, the whole sector will rally.

Fifth, small caps are no longer necessarily domestically focussed. The traditional view was that small caps were typically more exposed to domestic economies than large caps. However, thanks to globalisation, many small caps now operate with a global reach and are able to thrive despite woeful growth in their home country.

With all these factors in mind, small cap stocks should have a role to play in most diversified portfolios. Fortunately, ETFs provide an efficient way to gain exposure.

European Small Cap:

SPDR MSCI Europe Small Cap ETF

iShares EURO STOXX Small ETF

Source STOXX Europe Small 200 ETF

Source MSCI EMU Small Cap  ETF

PowerShares FTSE RAFI Developed Europe Mid-Small ETF

CS ETF (IE) on MSCI EMU Small Cap

Amundi ETF Euro Stoxx Small Cap 

Db X-Tracker MSCI Europe Small Cap TRN Index ETF

US Small Cap:

iShares S&P SmallCap 600 ETF

Source Russell 2000 ETF

Emerging & Asia-Pac Small Cap:

SPDR MSCI Emerging Markets Small Cap ETF

iShares MSCI AC Far East ex-Japan SmallCap ETF

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