Staying Passive With Small-Cap ETFs

The struggles of active managers over the past several years have been well documented. Plenty of folks appear on various financial media outlets year after year proclaiming this is a stock picker's market.

The thing is, stock-picking is difficult. Worse yet, data suggest there are not many great stock pickers out there. S&P Dow Jones data show 82 percent of active large-cap managers failed to beat the S&P 500 over the past decade.

Maybe in theory, active management should work more to investors' advantage with small caps. The reality is, active small-cap managers are actually worse at beating their benchmark than their large-cap counterparts. Over the same 10-year period, more than 87 percent of small-cap active managers lagged the S&P SmallCap 600 Index, according to S&P Dow Jones.

Investors searching for small-cap exposure can eschew the usual cap-weighted funds, while sticking with the advantages of passive management and the exchange traded funds wrapper. Ideas include the fundamentally-weighted WisdomTree SmallCap Earnings Fund (ETF) (NYSE:EES) and the dividend-weighted WisdomTree SmallCap Dividend Fund (ETF) (NYSE:DES).

We think investors have a tendency to get excited about future growth potential and risk bidding up security prices past their fundamentals. We believe this risk tends to be greater in the small-cap space where you have higher growth expectations and more speculative companies, or companies that are not profitable or pay dividends, said WisdomTree in a note out Thursday.

A Closer Look At EES

EES combats the conundrum of small caps that are not profitable by following the WisdomTree SmallCap Earnings Index (WTSEI), which mandates that constituent companies have generated positive cumulative earnings over their most recent four fiscal quarters prior to the index measurement date, according to WisdomTree.

With that, it is not surprising that EES is lightly allocated to healthcare and energy names, arguably two of the more speculative small-cap sectors. Those groups combine for just 15.6 percent of the ETF's weight, less than the fund's allocations to financial services, industrial and consumer discretionary names.

Since the March 9, 2009, market bottom, EES has returned 348 percent compared to a gain of just over 290 percent for the S&P SmallCap 600 Index.

Although small caps have not been thought of as prime dividend destinations, dividend growth in the S&P SmallCap 600 has notably increased in recent years. Dividends also help reduce some of the volatility inherent with small-caps, as is highlighted by the WisdomTree SmallCap Dividend Fund. Since the March 9, 2009, market bottom, DES has been slightly less volatile than the Russell 2000.

A Closer Look At DES

DES features an even smaller combined energy/healthcare weight than EES at just over 8.3 percent. The small-cap dividend ETF allocates a combined 41.4 percent of its weight to financial services and consumer discretionary stocks, sectors that have been significant contributors to small-cap dividend growth in recent years.

All the passively managed DES has done since the 2009 market bottom is return 322 percent.

WisdomTree indexes, and the ETFs designed to track them, use rules-based methodologies to weight companies by their underlying fundamentals, such as dividends or earnings, because we believe that prices are not always the best determinant of a securitys value.

"Furthermore, WisdomTree rebalances its Indexes annually to adjust for relative value to help manage valuation risks, and we are pleased with the results thus far, said the issuer.

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