A Fundamentally Sound Small-Cap ETF
Small-cap stocks and exchange-traded funds have been in the news quite a bit recently and for all the wrong reasons. With the widely followed Russell 2000 Index and the S&P SmallCap 600 Index up an average of 2.2 percent year-to-date, or about a third of the gain posted by the S&P 500, some investors are growing concerned about the laggard status of smaller stocks.
Smart Beta ETFs
Some smart beta small-cap ETFs could merit attention in an environment that is becoming increasingly tricky for lower market value fare. An idea to consider is the Schwab Fundamental U.S. Small Company Index ETF (NYSE: FNDA).
FNDA, which debuted in August 2013, tracks the Russell RAFI US Small Co. Index, which includes the bottom companies that weight below 87.5 percent from the Russell 3000 Index. Earlier this month, Schwab lowered the annual fee on FNDA to 0.25 percent from 0.32 percent, making the ETF less expensive than the average smart beta ETF.
FNDA's underlying index “selects and weights securities using the average of three fundamental measures of company size including adjusted sales, retained operating cash flow and dividends plus buybacks,” according to FTSE Russell.
FNDA also has a method for avoiding big exposure to richly valued stocks.
“When it rebalances each quarter, the fund trims positions in stocks that have become more expensive relative to peers and increases its exposure to those that have become cheaper during the past year,” said Morningstar in a recent note. “These disciplined bets against the market should give the fund an edge against its market-cap-weighted value index peers if and when valuations mean-revert. However, this approach can also increase the fund's exposure to stocks with deteriorating fundamentals.”
FNDA holds 862 stocks, none of which account for more than two-thirds of a percent of the ETF's weight. Like many traditional small-cap ETFs, FNDA's sector allocations are highly cyclical with industrial, consumer discretionary and financial services names combining for almost 52 percent of the ETF's roster. Conversely, defensive consumer staples and utilities names combine for just 7 percent of FNDA's weight.
Over the past three years, FNDA's annualized volatility has been 15.2 percent, compared to an average of 16.5 percent for the Russell 2000 and the S&P SmallCap 600.
“At times, the fund's active weightings can add up to large sector bets. The fund currently has greater exposure to industrials and consumer cyclicals than the Russell 2000 Index and less exposure to healthcare stocks,” said Morningstar. “Its holdings tend to trade at slightly lower average multiples of forward earnings than the constituents in the Russell 2000 Index. The portfolio also has a modestly larger market-cap orientation than that benchmark.”
The research firm has a bronze rating on FNDA.
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