Factor Focus With Small-Cap ETF Investing Play

MarketsETF Trends

This article was originally published on ETFTrends.com.

Small-cap stocks are often prized for growth while some investors tap the value factor with smaller companies. Investors looking for a multi-factor approach to U.S. small-caps should consider the Xtrackers Russell 2000 Comprehensive Factor ETF (NYSEARCA: DESC).

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DESC tracks the Russell 2000 Comprehensive Factor Index. That benchmark “is designed to provide transparent, cost-efficient exposure to small-cap domestic equities based on five factors – Quality, Value, Momentum, Low Volatility and Size,” according to Deutsche Asset Management.

Traders have often used single factor ETFs to tactically increase or decrease exposure to a desired factor or rotate out a factor exposure in a changing market environment. But there are risks with single factor strategies.

Quality is now the most expensive of all four valuation multiples while value is the least expensive. Potential investors, though, should keep in mind that value has the second lowest expected earnings-per-share growth rate among the major factors, the highest debt-to-equity ratio and lowest return on equity. Meanwhile, momentum has the highest expected earnings growth.

Value stocks typically cover companies that trade at a lower price relative to fundamentals such as dividends earnings and sales, which are then considered undervalued by a value investor.

DESC, which turns two years old in June, holds 1,454 stocks. The ETF allocates over 26% of its weight to the financial services sector and over a third of its combined weight to industrial and consumer discretionary stocks.

DESC is also a credible play on the recently passed tax reform legislation. Specifically, smaller companies have historically paid a higher effective tax rate partly because they can not shield earnings abroad in lower tax jurisdictions. The median effective tax rate for the Russell 2000 companies was 31.9%, compared to the 28% for those in the large-cap S&P 500.

Small-cap companies are also domestically focused, with the average Russell 2000 company only generating about 20% of revenue for overseas sources, compared to S&P 500 companies that generate over 40% of revenue from abroad in 2016. Consequently, a greater percentage of these small-cap companies’ revenues and earnings will be taxed at the lowered 21% rate.

Additionally, small companies typically benefit from a faster economic expansion, which may occur under a more lax tax scheme. Furthermore, small-caps are great targets for mergers and acquisitions in an growing economic environment.

DESC charges 0.30% per year, or $30 on a $10,000 investment, a favorable fee among smart beta small-cap strategies.

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