Which ETF To Choose: Small Cap Vs. Large Cap

By Gregory S. Davis | March 09, 2009 AAA

Conventional wisdom holds that small cap stocks tend to outperform large cap stocks over extended periods of time. With the Dow Jones Industrial Average (DJIA) sitting below 7,000, thoughts concerning which asset class will take the lead during the eventual recovery should be entering the minds of investors. Let's take a look at exchange traded funds (ETF), focusing on small and large capitalization stocks and the betas of the underlying stocks, to determine the way forward.

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A Rare Up-Day
In a rare occurrence, the DJIA closed up 2.23% on March 4. This is a sampling of the best-performing ETFs in the asset classes.

ETF by Asset Class Name Intraday Return
Small Cap Growth PowerShares Cleantech
(NYSE:PZD)
5.79%
Mid Cap Growth iShares Russell Midcap Growth Index
(NYSE:IWP)
3.96%
Large Cap Growth SPA MarketGrader Large Cap 100
(NYSE:SZG)
3.56%

As a point of reference, investors should note that the three-year return for the SPDRS S&P 500 Index (NYSE:SPY), which tracks the S&P 500, is a negative 16% through March 4 of this year.

Small Cap Reasoning
Part of the thinking behind small caps outperforming large caps centers around the issue of risk. Greater levels of risk are expected to yield higher levels of return. The expectation of greater returns could possibly explain why the PowerShares Cleantech fund was the best performing small cap growth ETF on March 4. PZD is comprised of technology and clean energy companies including AutoDesk (Nasdaq:ADSK) and First Solar (Nasdaq:FSLR). AutoDesk and First Solar have relatively high betas of 2.26 and 2.04 respectively. (To learn more about beta, and how it can be used to increase your returns, read Betting Your Portfolio With Alpha And Beta.)

Large Cap Reasoning
The SPA MarketGrader Large Cap 100 claimed the top spot for the day on March 4. This signals the potential for life in SZG's focus areas of energy, industrial materials and information technology hardware. Top holdings include precious metals miner Barrick Gold Corporation (NYSE:ABX) and education provider Apollo Group (Nasdaq:APOL), operator of the University of Phoenix. Both companies are larger in terms of market capitalization than the typical PZD holding. In addition, ABX and APOL each have much lower beta ratios of 0.53 and 0 respectively. A beta of 0 suggests no correlation to the performance of a broad market index like the S&P 500. True to form, Apollo Group stock has returned approximately 21.60% over the past year through March 5, while the S&P 500 has lost approximately 48% of its value over the same time period.

Final Thoughts
To come out ahead, investors should focus on building a diversified basket of holdings while keeping an eye on the mix of betas in their funds' underlying securities. The next important step is to periodically rebalance. Small caps may take the lead in the short term and large caps may retake the lead in the future; the investor who can make adjustments to account for these changes is likely to gain an advantage.

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