How To Deal With Small-Cap Volatility

Investing in small-caps, even exchange traded funds, can be trying because smaller stocks are consistently more volatile than their larger peers. Even in good years for small-caps, investors will usually have to endure at least one nasty drawdown.

There are ways, however, for buy-and-hold investors to effectively deal with small-cap volatility.

Various investment factors can help investors limit small-cap volatility relative to traditional small stock strategies. However, not all investment factors are adept at trimming small-cap drawdowns. An avenue for generating income and potentially reducing small-cap drawdowns is the WisdomTree SmallCap Dividend Fund DES.

“The crucial question regards whether these premiums reduced the average drawdown experienced by small caps broadly, and an additional focus of interest is on the differences between small-cap value and small-cap growth, small-cap high quality and small-cap low quality, and small-cap high momentum and small-cap low momentum,” WisdomTree said in a recent note.

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DES is outperforming small-cap growth stocks over the past three years, and over the past decade, DES's underlying index hasn't lagged the Russell 2000 Growth Index by much. DES can be viewed as a quality factor play with value tilts. For skittish investors, those are favorable traits because historical data suggest small-cap quality and value stocks usually experience lower drawdowns than the broader small-cap space.

Not surprisingly, the strategy offered by DES is also likely to incur lower drawdowns compared to small-cap growth stocks or those smaller stocks with low quality traits.

DES has some other advantages. Notably, it charges just 0.38 percent per year in fees, which is about 100 basis points less than the average actively managed small-cap growth fund. Plus, DES isn't saddled with the long-term track record of mediocre (or worse) performance as are many actively managed small-cap mutual funds.

“Small value also tended to, on average, exhibit drawdowns 2.6% less than a broad exposure to small caps. In fact, tilting toward higher quality or momentum also tended toward less-severe drawdowns than small caps broadly,” WisdomTree said.

DES allocates a combined 37.7 percent of its weight to consumer discretionary and industrial names. Small-cap energy and healthcare stocks, which can often be more volatile than the broader small-cap space, combine for less 7 percent of the ETF's weight.