Last year was a recovery year for U.S. stocks. The Wilshire 5000 Index, a broad benchmark of U.S. common stocks, returned 29.3% in 2009. It was a size-segmented market, with some returning considerably more than others. A remarkable picture emerges when we look at different indexes that segregate by company size. (For background reading, see How To Evaluate A Micro Cap Company.)

2009 Return (%) U.S. Index Percentage of Market
24.8 Morningstar Large Cap Stocks 70
39.0 Morningstar Mid Cap Stocks 20
37.7 Morningstar Small Cap Stocks 7
47.6 Wilshire Micro Cap Index < 3
81.7 CRSP Decile 10 Index < 1

One part of the market was almost shocking, particularly for those investors who own tiny micro-cap stocks through index funds and ETFs. The Wilshire U.S. Micro-Cap index was up

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47.6%, and the CRSP Decile 10 Index, which measures the smallest micro-cap stocks, registered a whopping 81.7% gain. (The Wilshire U.S. Micro-Cap index represents all stocks below the 2,500th rank by market capitalization; the CRSP Decile 10 Index is based on the Center for Research in Security Prices methodology. CRSP divides all NYSE companies into 10 size deciles from largest to smallest and then fills those deciles with Nasdaq and NYSE Amex stocks based on comparable size.)

You may think that with micro-cap returns like these, micro-cap index fund investors would be jumping for joy. But they're not. Why? Because the returns of all micro-cap index funds were well below these returns, so low that they didn't even reach the Wilshire 5000 return. Below are the four micro-cap index funds screened from Morningstar's Principia database, along with the number of stocks in each fund and the weighted market capitalization of those companies.

Fund Name Ticker 2009 Return Number Holdings Geo Market Cap (Millions)
Bridgeway Ultra-Small Company Market BRSIX 26.0 511 165
iShares Russell Microcap ETF IWC 23.7 1305 221
First Trust Dow Jones Select MicroCap ETF FDM 20.0 267 312
PowerShares Zacks Micro Cap ETF PZI 12.1 401 287

What is the problem with micro-cap index funds and ETFs? The problem is that there are no true micro-cap index funds or ETFs. They don't exist. They can't exist because most micro-cap stocks are not investable.

Many companies in the micro-cap segment have tiny floats and no trading volume and that makes them very difficult for funds to buy. Other stocks have market prices less than $1 per share and are off-limits to fund managers due to company policy. Yet in 2009, these non-investable segments produced superior returns in the micro-cap segment.

Illiquidity and buying restrictions aside, I am not going to let the micro-cap funds off so easily - each fund had its own internal issues that added to underperformance.

Bridgeway Ultra-Small Company Market (BRSIX) has a mandate to invest in CRSP Decile 10 stocks. However, the fund is currently only 65% in those stocks. The rest are in larger companies that returned less. However, the biggest reason for the fund's underperformance was the fundamental overlay that management puts on the stock selection. This screen keeps stocks with poor fundamentals out of the fund, and those stocks happened to be the best-performing part in the micro-cap market.

iShares Russell Microcap ETF (IWC) attempts to track the Russell Microcap Index. The index comprises the smallest 1,000 stocks in the Russell 2000 small-cap index, plus the next 1,000 stocks under that. For the record, I don't view the Russell Microcap as a true micro-cap benchmark because, by design, at least half the stocks are small-cap (not micro). IWC returned 23.7% in 2009, below the 27.5% Russell microcap index return and far below the Wilshire microcap index.

First Trust Dow Jones Select MicroCap ETF (FDM) follows the Dow Jones Select MicroCap Index. This index is designed to represent micro-cap stocks trading on the NYSE and Nasdaq Stock Market that are comparatively liquid and have strong fundamentals relative to the micro-cap market as a whole. This index was up only 21.9% last year, confirming Bridgeway's reasoning that fundamentally strong stocks underperformed. Still, FDM earned 20%, missing its own index by 1.9%.

Finally, there is the bottom-scrapping 12.1% return from the PowerShares Zacks Micro Cap ETF (PZI).This fund follows the Zacks Micro Cap Portfolio. It's hard to say why this fund performed poorly because the index description in the prospectus is so vague. All it says is that Zacks has a "proprietary composite scoring system based on relative value and momentum" - whatever that means. Index providers tend to be secretive about their methodology when they don't want competitors stealing their ideas. In this case, I don't think Zacks has anything to worry about.

I like micro-cap stocks and believe that having a small allocation in a portfolio will help your long-term return without adding much risk. Micro-cap stocks tend to be mutually exclusive from most broad U.S. equity benchmarks, and their performance tends not to correlate highly with the rest of the market. This creates a diversification benefit.

We have owned micro-cap stocks using the Bridgeway Ultra-Small Company Market fund for many years and will continue to hold it. The long-term return of BRSIX is close to the CRSP 10 Index, and the weighted capitalization is lower than any other micro-cap index funds. In addition, the expense ratio is a reasonable 0.75%.

The best alternative for ETF-only investors and model builders would be the iShares Russell Microcap ETF. Although the Russell Index is not a true micro-cap benchmark, it is closer than the other two mentioned earlier. The fund expense is 0.68%.

Micro-cap stocks do offer diversifications benefits, and although 2009 was a disappointment, I believe putting a small amount of your equity allocation in this market segment will benefit your portfolio in the long run.

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