IWM, VB, FYX: Three Ways to Ride the Rally in Small Cap Stocks

A recent surge in small cap stocks - companies with a market capitalization of under $1 billion - means individual investors should be placing at least a few of their chips in the small-cap arena.

In fact, the rally has pushed the Russell 2000, an index of 2,000 small cap stocks, to within shouting distance of record highs.

The benchmark has climbed a whopping 34% since its lows in early October and is within 5.8% of its closing high of 865.29 set back in April.

By comparison, the Dow Jones Industrial Average, which earlier this month hit 13,000 for the first time since 2008, is still 7.9% from its record high in October 2007.

Yet many investors haven't been around to enjoy the ride.
Since the end of April 2011, small-cap mutual funds have seen $15.9 billion in outflows, and small-cap exchange-traded funds (ETFs) have seen $4.4 billion withdrawn.

That's probably because large-cap stocks outperformed their smaller brethren posting an 8.5% premium over them from April through September.

According to CBS News, investors have been voting with their feet, yanking money out of small-cap mutual funds in 37 of the 40 weeks since May.

But so far in 2012, that trend has begun to change.
Since the start of the year, investors have actually sunk about $2.4 billion back into small cap stocks, according to data provided by Lipper Inc.

That ongoing surge in small-cap stocks demonstrates investors are now willing to take on more risk, market participants say.

"It is a decent confidence barometer," Scott Wren, a senior equity strategist for Wells Fargo Advisors told The New York Times. "Investors are confident enough to buy some of these small companies, betting that the U.S. economy is going to continue to grow."

Why You Should Own Small Cap Stocks

Historically small-cap stocks have been an individual investor's best friend.

Since 1927, a small-cap portfolio has easily beaten the returns of large-cap by an average of nearly 3%.

So why do small cap stocks outperform their larger cousins?

First of all, big investors like mutual and pension funds manage billions in assets, making it difficult to buy and sell small stocks without having a huge influence on the price. As a result, a fund manager may find himself chasing a stock higher as he tries to take a meaningful position simply because he's the only big buyer.

Second, because the big fish attract the big bucks, small cap stocks are often ignored by Wall Street analysts.

Most analysts aren't about to spend precious hours researching a company that no one follows. That is especially true when they have big investors chomping at the bit for the latest intelligence report on a closely monitored blue-chip.

"Most analysts at major firms get attention and make their reputations by emphasizing big cap recommendations. Small stocks present the individual investor with a better potential to achieve greater prominence in the future as their market caps expand," said former Wall Street analyst Stephen T. McClellan.

How to Invest in Small Cap Stocks

Small cap stocks may offer the ultimate risk-versus-reward potential to investors, but they also come with added caution.

And while reduced coverage of small caps on Wall Street can be viewed as good news, it will force individual investors to be more patient with investments because it may take time for the big money to catch on to the next big thing.

It also means having to get your hands dirty.

If you aren't ready to sharpen your pencil and spend considerable time researching a small cap company, you're probably better off letting the experts do the work by buying an ETF.

Here are three small cap ETFs worth a look:

1) iShares Russell 2000 Index ETF (NYSEArca: IWM)

The biggest exchange traded fund in the U.S. small cap sector, IWM registered net outflows of $2.3 billion in 2011, but was still the 14th largest U.S. listed ETF at the end of last year with assets of $14.1 billion. IWM tracks the Russell 2000 index and currently yields 1.3%. Its year to date (YTD) return is 7.15% and it carries an expense ratio of 0.26%.

2) Vanguard Small-Cap ETF (NYSEArca: VB)

VB follows the MSCI U.S. Small Cap 1750 Index, which consists of 1750 small cap stocks in U.S. markets. Its annual dividend yield is 1.27% and YTD return 6.95%. The expense ratio is 0.15%.

3) First Trust Small Cap Core AlphaDEX ETF (NYSEArca: FYX)

FYX follows the Defined Small Cap Core Index, an "enhanced" index created and administered by Standard & Poor's that selects stocks from the S&P Small-Cap 600 Index. The expense ratio is 0.70%. The ETF yields 0.19% and YTD return is 7.52%.

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