Small-Cap Value Etfs: Risky But Worth It?

Small-cap ETFs can be a great addition to your investment portfolio, but they come with some risks. Small-cap stocks are defined as those with a total value of shares outstanding between a few hundred million dollars and a few billion dollars. They are considered small because, in the stock market, market capitalization can hit a trillion dollars. Small-cap stocks are often riskier and more volatile than large-cap stocks, but they can offer higher potential returns.

Small-cap ETFs are a good way to invest in small-cap stocks because they allow you to purchase a diversified portfolio of smaller companies at a relatively low cost. They also don't require the extensive research that investing in individual companies does. However, as the most successful companies grow, they move on from being considered small-cap, and many funds are forced to sell them to stay within their investment objectives. Small-cap funds can also be more volatile than funds that hold larger, more established companies.

So, while small-cap ETFs can be a great investment, they are not without their risks and drawbacks. It is important to carefully consider the potential benefits and drawbacks before investing 100% in small-cap ETFs.

Small-cap ETFs can be riskier than large-cap stocks

Firstly, small-cap companies have less financial flexibility than larger companies. They tend to rely more on debt and are more sensitive to interest rates, which can make them vulnerable to economic downturns. This sensitivity to interest rates also means that small-cap companies are heavily reliant on domestic consumer spending, which tends to slow when interest rates rise. Consequently, small-cap stocks have been under pressure from high-interest rates.

Secondly, small-cap companies are more likely to be affected by negative events. For example, if a single company goes out of business, this could have a significant impact on the overall performance of a small-cap ETF. In contrast, large-cap stocks are often more established and less susceptible to individual risks.

Thirdly, the small-cap market is evolving, and some argue that it is atrophying. Many promising young companies are choosing to stay private for longer, seeking growth capital from private shareholders instead of entering public markets. As a result, much of their growth occurs before they become subject to the scrutiny and regulations of public trading. This means that by the time these companies go public, their growth potential may be diminished, reducing the appeal of small-cap ETFs.

Finally, small-cap stocks are subject to higher volatility and illiquidity, which can make them riskier investments.

However, it's important to note that small-cap ETFs can provide benefits such as diversification and the potential for higher returns. They can be a good option for investors who are comfortable with the associated risks and are looking to add smaller companies to their investment portfolios.

Small-cap ETFs can be more volatile than funds with larger companies

Small-cap stocks are also more sensitive to interest rates, which can fuel their growth during low-rate environments. However, they may underwhelm when rates are high and markets are shaky. This is because small-cap companies are more heavily reliant on domestic consumer spending, which tends to slow when interest rates rise.

Small-cap ETFs can provide attractive returns, but investors should be aware of the risks involved. These funds allow investors to purchase a diversified portfolio of smaller companies for a relatively low cost. They can also be added to an overall portfolio to boost exposure to the small-cap universe. However, as the most successful small-cap companies grow, they may move on from being considered small-cap, and many funds are forced to sell them to stay in line with their investment objectives.

Small-cap funds also tend to be more volatile than funds holding larger, more established companies. This volatility can amplify drawdowns. Additionally, small-cap stocks are less liquid, which creates a drag on returns. This lack of liquidity means that small-cap ETFs may have to settle for unfavourable prices when tracking their benchmark index during rebalancing.

Small-cap ETFs can lack the broad diversification of other funds

Small-cap ETFs can be a great addition to your investment portfolio, but they do come with some risks. One of the main risks is their lack of broad diversification.

Small-cap ETFs invest in small companies with a value of less than $2 billion, which means they are already a niche investment. Additionally, small-cap ETFs tend to focus on specific sectors, such as financials, industrials, and consumer discretionary. This can make them more vulnerable to economic downturns or shifts in the market that impact those specific sectors.

For example, the Dimensional U.S. Small Cap ETF (DFAS) has financials, industrials, and consumer discretionary as its top three sectors. The Avantis U.S. Small Cap Value ETF (AVUV) also has a similar sector focus. This concentration in a few sectors can limit the diversification benefits of an ETF.

Furthermore, small-cap ETFs often have a significant portion of their holdings in a small number of companies. For instance, the top 10 holdings of the DFAS account for 3% of its net assets, while the AVUV's top 10 holdings make up 9%. This concentration can increase risk, as the performance of a few companies can have a larger impact on the overall returns of the ETF.

Small-cap ETFs also tend to have higher fees associated with them due to active fund management. While some small-cap ETFs, like the DFAS, manage to keep fees low, many others charge higher expense ratios for active management.

In conclusion, while small-cap ETFs can provide some diversification benefits, they often lack the broad diversification of other funds. They tend to focus on specific sectors and have concentrated holdings, which can increase risk. Additionally, higher fees can also be a consideration when investing in small-cap ETFs.

Small-cap ETFs can be impacted by economic developments

Firstly, small-cap ETFs are susceptible to economic conditions and can be impacted by interest rate changes. When interest rates are high, small-cap companies may be adversely affected as they tend to rely more on debt than large-cap companies. High-interest rates can also lead to a slowdown in domestic consumer spending, which small-cap companies rely on heavily. As a result, small-cap ETFs can be sensitive to interest rate fluctuations and may underperform during periods of high-interest rates.

Secondly, small-cap ETFs may not provide the same level of diversification as other funds. If an economic development negatively impacts the small-cap market, investors may not be protected due to the lack of broad diversification. Small-cap ETFs tend to focus on specific sectors, such as financials, industrials, and consumer discretionary stocks, making them more vulnerable to sector-specific risks.

Thirdly, small-cap ETFs tend to be more volatile than funds holding larger, more established companies. The smaller companies in these ETFs may be more sensitive to market fluctuations and economic changes, leading to higher volatility in the fund's performance.

Finally, as successful small-cap companies grow, they may outgrow the definition of a small-cap and be forced to leave the ETF to maintain its investment objectives. This means that investors could miss out on the continued growth of these companies if they are no longer part of the ETF's holdings.

In conclusion, while small-cap ETFs can offer higher returns and provide access to some of the market's fastest-growing companies, they also come with risks and drawbacks. It is essential to consider the potential impact of economic developments on small-cap ETFs and diversify one's investments accordingly.

Small-cap ETFs can be costly to rebalance

On a rebalancing date, an ETF may have to move a significant portion of a small stock's outstanding share count. This is because index ETFs are beholden to their benchmark and can become forced buyers or sellers, sometimes having to settle for unfavourable prices. While the difference in price may be small, it adds up when dealing with hundreds of small stocks. Therefore, the approach to rebalancing and turnover is particularly important for small-cap ETFs.

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