Size is one of the most widely followed investment factors. The conventional wisdom ascribed to the size factor is that, over long holding periods, smaller stocks can outpace large caps. However, that outperformance often comes with small caps being more volatile than their larger peers.
During the current bull market, those trends have held true. Since the birth of the current bull market on March 10, 2009, the Russell 2000 Index and the S&P SmallCap 600 have returned an average of 383 percent compared with a gain of "just" 284 percent for the S&P 500. But volatility has been predictably higher for the small-cap benchmarks. In this bull market, average annualized volatility for the two small-cap benchmarks has been about 21.4 percent compared with 16.1 percent for the S&P 500. (See also: Small Caps Boast Big Advantages.)
The world of smart-beta exchange-traded funds (ETFs) gives investors alternatives for small-cap exposure, some of which have the potential to enhance returns with smaller stocks while reducing volatility. While the WisdomTree SmallCap Dividend Fund (DES) has been only slightly less volatile than the aforementioned small-cap benchmarks during this bull market, that ETF has returned a staggering (almost) 400 percent. As a dividend ETF, DES avoids some of the more speculative, profitability-challenged names that are found in some small-cap funds. DES weights its holdings by dividends paid. (See also: DES Fund for US Dividend-Paying Small-Cap Stocks.)
Proving the point that profitability can make a significant difference with small caps, there is the WisdomTree SmallCap Earnings Fund (EES). While EES has been slightly more volatile than traditional small-cap indexes during this bull market, the risk-adjusted returns prove that EES has been a winner. The ETF has returned a whopping 435.1 percent during this bull market.
"By avoiding the small caps with lower operating profitability and focusing on those with higher profitability, there was a return advantage over simply focusing on small caps alone," said WisdomTree in a recent note. The index EES tracks, which is weighted by earnings, is home to just over 800 stocks that meet an important requirement – they must have posted cumulative earnings for the four quarters prior to entering the index. (See also: ETF Analysis: WisdomTree SmallCap Earnings.)
While DES and EES are obviously small-cap ETFs, indicating that the size factor is somewhat at play here, they can also be seen as quality funds by virtue of their focuses on profitability. "Intuitively, the requirement of paying ongoing dividends or generating positive profits could lead to a focus on higher quality, predominantly by avoiding the more speculative firms that may not meet these criteria," said WisdomTree. DES is more than 10 and a half years old, while EES celebrated its 10-year anniversary last month. (See also: Top 3 Small-Cap ETFs for 2017.)