Investing in Small Cap Stock Sectors With New ETFs

By: Ron_Rowland

The exchange traded fund (ETF) menu is getting bigger all the time. Many of the new ETFs you hear about are just “me-too” clones of existing funds. But every once in a while something truly innovative comes along. When it does, I try to tell you about it.

Today I’m excited about the potential for PowerShares Small Cap Sector ETFs. Finally, two great ETF flavors come in the same package. And finally, we can go deeper into the sectors with other than just a handful of large, well-known stocks.

To understand how significant this is, you need to be aware of how the Standard & Poor’s index family works. So let’s start there …

You’ve probably heard about the S&P 500 Stock Index — the well-known benchmark widely used as a proxy for the U.S. stock market.

This particular group of 500 companies is selected by a committee at S&P to represent the U.S. large cap stock universe.

S&P indexes cover more than large cap stocks.

However, the S&P 500 is just one capitalization component of any significance in the U.S. equity markets.

There is also the:

• S&P MidCap 400 Index, and the
• S&P SmallCap 600 Index

Each of the three capitalization-based indexes can be further broken down by industry sector. And S&P publishes index data for all these niches: S&P 500 Health Care Index, S&P SmallCap 600 Technology Index, and so forth.

As I wrote last year in my Money and Markets column Unbundle the Stock Market with Sector ETFs, the Select Sector SPDR ETFs allow investors to customize their sector allocations within the S&P 500 index. With those ETFs you can overweight, underweight, concentrate on, or omit completely any large cap stock sector you wish.

Unfortunately, there was no way to do the same for the S&P 600 small caps or the S&P 400 mid caps. Until now …

PowerShares Fills the Void

Thanks to PowerShares, now at least part of the gap is filled. On April 7 the company launched a suite of nine small-cap sector ETFs based on the S&P 600 indexes. Here are the new ETFs and their ticker symbols …

• PowerShares S&P SmallCap Consumer Discretionary (XLYS)
• PowerShares S&P SmallCap Consumer Staples (XLPS)
• PowerShares S&P SmallCap Energy (XLES)
• PowerShares S&P SmallCap Financials (XLFS)
• PowerShares S&P SmallCap Health Care (XLVS)
• PowerShares S&P SmallCap Industrials (XLIS)
• PowerShares S&P SmallCap Information Technology (XLKS)
• PowerShares S&P SmallCap Materials (XLBS)
• PowerShares S&P SmallCap Utilities (XLUS)

A new family of ETFs lets you invest in small caps and sectors all at the same time.

Observant readers will notice that the ticker symbols for these funds are the same as those for the large cap sector SPDR ETFs, with an “S” added at the end of each. This is handy, and also amusing because PowerShares and SPDR are not related to each other. In fact, they’re competitors for ETF market share!

These new ETFs open up a whole new frontier for investors who like to rotate between industry sectors. And because there is no overlap between the S&P 500 stocks and the S&P 600 stocks, these new PowerShares can be expected to perform differently than their big brothers.

This gives astute investors more ways to diversify — and more profit opportunities since small cap stocks usually outperform bigger stocks over long time periods.

Consider the Consumer Staples sector …

For the ten-year period ending December 2009, the small cap index covering this sector had an annual average return of 11.9 percent. Meanwhile the equivalent large cap index averaged only 5.2 percent.

In other words, small cap stocks earned more than twice as much per year as large caps within the same industry sector. Comparing cumulative performance it was 207 percent versus just 66 percent. Wow!

It’s not just consumer staples, either. Small caps outperformed in all nine sectors over this ten-year period.

So whether you’re a buy-and-hold investor or a short-term trader, you now have a great new tool to hang on your investment tool belt.

Should you use this tool?

Just like screwdrivers and wrenches, not every tool is right in every situation. Small caps may have more growth potential, but they’re also more volatile …

Know the risks and use these ETFs wisely. As with all new ETFs, it will take some time for liquidity to develop, so be sure to use limit orders in the meantime.

Best wishes,

Ron

P.S. Are you following me on Twitter? Check out http://www.twitter.com/ron_rowland for frequent updates, personal insights and observations about the world of ETFs.

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