An ETF For Gains From The Equity Market's Smallest Corner

Micro-cap stocks are an alluring yet confounding segment of the market. Stocks in this segment are generally considered to have market values ranging from $50 million to $300 million.

Taking Off Some Micro-Cap Volatility Risk 

Due to those low numbers, micro-cap names typically lack analyst coverage and significant institutional buying. Even without those traits, the asset class offers significant upside potential. But stock picking among the smallest of the small can be difficult.

Enter the iShares Micro-Cap ETF IWC, which includes stocks with market values up to $1 billion, taking some of the volatility edge off micro-cap investing.

Micro-Cap Benefits, Risks 

“However, this asset-class is not without its drawbacks. Chief among these are greater volatility and limited liquidity and capacity,” Morningstar said in a recent note.

“Also, for fund investors, there are few options for exposure to this sliver of the market. It is a market segment where indexing is challenged. Fortunately, there are some better alternatives.”

The $836.6-million IWC, which tracks the Russell Microcap Index and holds nearly 1,400 stocks, is one of those alternatives.

This segment of the market may hold potential benefits within the context of diversified equity allocation, Morningstar said. 

“Most notably, micro-caps have some diversification potential. This is evidenced by the fact that they are not perfectly correlated to other segments of the U.S. market-cap spectrum.”

In other words, investors with large-cap heavy portfolios may want to consider IWC not just for the size effect benefits, but the benefits of reduced correlations as well.

'The Primary Drawback' Of Micro-Caps 

IWC has perks, but there are disadvantages to be expected. An obvious one is that many micro-cap companies aren't profitable or are in outright financially precarious positions.

“The primary drawback of investing in micro-caps is their higher volatility compared with large-, mid- and small-cap stocks,” according to Morningstar. “Also, the costs of obtaining information on these companies and monitoring them tends to be higher as they receive less — if any — attention from Wall Street.”

IWC allocates nearly half its combined weight to the financial services and health care sectors. The former gives the fund some steadiness and exposure to smaller, but profitable banks with value stock appeal.

Micro-cap healthcare names usually dwell in the biotechnology and medical device spaces, meaning they are reliant on regulatory approvals and probably aren't close to profitability. As a trade-off, those stocks offer significant growth potential.

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