Follow the Trend with Small-Cap Growth ETFs

With exchange traded funds (ETFs), global stock markets can be sliced and diced in hundreds of different ways. You can invest by country, by geographic region, by industry sector, and by various combinations of all these.

Another way to look at the picture is by company style. Some stocks are more tilted toward growth and others toward value.

In a growth stock, the company is still trying to expand and probably reinvests a big part of any profits back into its business. Apple (AAPL) is a good example.

Value stocks, typically found in more mature industries, tend to be more stable and throw off regular income via dividends. Altria (MO) is a well-known value stock.

Style-based investing is frequently combined with market capitalization that breaks down companies by their size. From smallest to largest, you might have micro-cap, small-cap, mid-cap, large-cap, and mega-cap.

Put the two methodologies together and you get the familiar 9-square “style box,” originated by Morningstar, containing segments like large-cap growth and mid-cap value. Momentum shifts around through these categories based on economic and market conditions.

Stay ahead of the wave and you can make a tidy profit. Get behind it and you can lose your shirt.

Small-Cap Growth Zooming Ahead!

Right now, my proprietary indicators show a sharp divergence between the best and worst corners of the style box. Small-cap growth is moving up way faster than anything else. Over the last few months, my analysis shows a key small-growth benchmark is climbing at a 40 percent annualized rate!

Meanwhile, large-cap value, while not trending down, is nowhere near as attractive. The large value index I watch is growing at a relatively mild 10 percent annualized rate.

Why is this happening?

One reason may be that stock market investors are increasingly willing to take on risk — something that is definitely found in small-growth stocks. At the other end of the scale, large-value benchmarks are dominated by banks and other sectors that are relatively unattractive right now.

Yes, we’re looking in the rear-view mirror here, and the near future may or may not resemble the recent past. That’s always the case. Nevertheless, I’ve found that following the trend is usually a good strategy.

If you’re an equity trend-follower, then you need to take a strong look at the small-growth niche. Here are some ETFs you may want to consider.

These two track the Russell 2000 Growth Index:

• iShares Russell 2000 Growth (IWO)
• Vanguard Russell 2000 Growth (VTWG)

And these ETFs try to match the S&P 600 Small Cap Index:

• iShares S&P SmallCap 600 Growth (IJT)
• Vanguard S&P Small-Cap 600 Growth (VIOG)

This raises an interesting question …

If Two ETFs Follow the Same Index,
Which Should You Buy?

There are a couple of factors to consider …

First, which fund has the lowest expense ratio?

Operating costs are critical in an index fund. As long as the fund sponsor is a large, well-known firm (as both iShares and Vanguard are), there is no reason to pay any more than you must. The two Vanguard ETFs have a slight edge with expense ratios of 0.20 percent vs. 0.25 percent for both iShares offerings.

Second, look at liquidity and trading costs.

IWO and IJT are both heavily traded and have minimal bid-ask spreads. VTWG and VIOG are relatively new and haven’t built up large trading volumes yet. But I think it’s just a matter of time.

For individual investors, trading commissions may be a bigger factor. And if you have an account at the right brokerage, you can trade the above four ETFs for free.

For instance, clients of Fidelity Brokerage can trade IWO, IJT and some other iShares products with no transaction fee. Vanguard offers fee-free trading for VTWG and VIOG through its own brokerage affiliate.

So if you are already set up with Fidelity, you are probably better off with the iShares ETFs. Vanguard fans will likely find their firm’s proprietary ETFs are more cost-effective.

For more sophisticated traders, now may be a good time to capitalize on the wide momentum spread between small-growth and large-value. You can do this by pairing one of the small-growth ETFs with ProShares UltraShort Russell 1000 Value (SJF).

This ETF seeks daily investment results, before fees and expenses, that correspond to twice (200 percent) the inverse (opposite) of the daily performance of the Russell 1000 Value Index. Since SJF is leveraged and the other ETFs named above are not, you’ll need to adjust the amount you invest in each accordingly.

Will the trend change?

You bet it will! I fully expect to see the tables turned at some point, when we will see small-cap growth lag behind large-cap value. Will it be soon? That’s a tougher question. All I can say is that right now, small-growth is the style to consider owning.

Best wishes,

Ron

P.S. This week on Money and Markets TV, we check in on the health of the U.S. economy, and offer our prognosis for the pace of recovery in 2011.

So for some concrete investment ideas, based on the economic outlook of all the Weiss Research editors, be sure to tune in tonight, December 9, at 7 P.M. Eastern time (4:00 P.M. Pacific).

Simply go to www.weissmoneynetwork.com and follow the on-screen instructions. Access is free and no registration is required.