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Investing in the Small Cap Effect with ETFs

Small cap U.S. indices have a history of outperforming Big Cap indices from the middle of December to at least the end of February. Will the “Small Cap Effect” happen again this year?

Thackray’s 2012 Investor’s Guide notes that the Russell 2000 Index outperforms the Russell 1000 Index from December 19^th to March 7^th. The Russell 2000 Index has gained in 25 of the past 32 periods for an average gain per period of 5.5 percent. It also outperformed the Russell 1000 Index by an average of 3.3 percent per period.

Small Cap equities and Exchange Traded Funds tend to come under pressure during October, November and early December each year due to a series of annual recurring events. Tax loss selling pressures by individual investors take their toll during this period. In addition, year-end “window dressing” by institutional investors has a negative influence. Institutional investors prefer not to show large holdings in “high beta” small cap stocks when they release their annual reports. As well, institutional investors, who are having a profitable year, often prefer to own Big Cap stocks with lower volatility near year end as the time for calculating their final performance bonus approaches.

Weakness until mid December normally sets the stage for a significant recovery in the sector near year end. Frequently, the recovery starts during the traditional Santa Claus rally period from December 15^th to January 6^th. Tax loss selling pressures are relieved. In addition, institutional investors start to look for equities with higher risk and greater potential return to set the stage for potential outperformance in the following year.

Frequently, top candidates are found within the Small Cap sector.

Small Caps are showing strength earlier than usual this year. Strength of the Russell 2000 Index relative to the S&P 500 Index has been positive since the beginning of October. The Index recently moved above its 50 day moving average at 712.88 and currently is testing resistance at 769.46. Preferred strategy is to accumulate small cap ETFs at current or lower prices.

The Small Cap sector is in a better position for earnings growth in 2012 than the Big Cap sector and its focus on international markets. Companies with smaller capitalizations will benefit more from low short term U.S. interest rates. The Federal Reserve’s “Quantitative Easing II” program assures that low short term rates will continue until at least the end of 2012. In addition, likely approval of an extension of the payroll tax cut before the end of the year will encourage domestic U.S. economic growth in the first half of 2012.

Several small cap Exchange Traded Funds (ETF) are available. The most actively traded U.S. small cap ETF is the iShares Russell 2000 Index (IWM $74.54). Units track performance of approximately smaller cap 2000 U.S. listed equities that are part of the broadly based Russell 3000 Index. Management Expense Ratio is 0.20 percent

Canadian investors can choose to purchase a hedged version by owning the iShares Russell 2000 Index traded on the Toronto Stock Exchange (XSU $16.19 Cdn.). Units trade in Canadian Dollars and are fully hedged against a decline in the U.S. Dollar. Management Expense Ratio is 0.35 percent.

iShares also offers the second most actively traded U.S. small cap ETF, iShares on the S&P Small Cap 600 Index (IJT $75.11). Units track the performance of the 600 small cap U.S. listed securities that are part of the S&P 1,500 Index. Management Expense Ratio is 0.20 percent

Vanguard offers the lowest cost ETF. Management expense ratio on the Vanguard Small Cap ETF (VB $70.98) is only 0.15 percent. The ETF tracks the performance of the MSCI U.S. Small Cap 1,750 Index.

iShares also offers a small cap Exchange Traded Fund consisting of Canadian stocks in the TSX Composite Index (XCS $15.61). Units track the performance of S&P/ TSX Composite stocks excluding S&P/TSX 60 stocks. Management expense ratio is 0.55 percent.

RUSSELL 2000 Index (^RUT) Seasonal Chart

Don Vialoux is the author of free daily reports on equity markets, sectors,
commodities and Exchange Traded Funds. . Daily reports are
available at http://www.timingthemarket.ca/. He is also a research analyst for
Horizons Investment Management Inc. All of the views expressed herein are his
personal views although they may be reflected in positions or transactions
in the various client portfolios managed by Horizons Investment Management.

Stocks mentioned in this post: IJT, IWM, VB, XCS, XSU

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