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Why You Consider ETFs That Track Smaller Companies

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Mega-cap stocks have dominated in this year’s rally, but exchange traded fund investors should not forget the role of small-capitalization stocks, especially in the nascent recovery phase of the traditional economic cycle.

“Allocating to smaller companies provides a unique set of risks that have historically been rewarded over time, but that may cause the companies to struggle in challenging economic environments. Yet, with the S&P 500 now having one-quarter of its exposure in six securities, and an economic recovery potentially acting as a catalyst for smaller firms, the size factor may be of interest to many investors,” Holly Framsted, Managing Director, US Head of Factor ETFs, BlackRock’s ETF and Index Investments Group, said in a research note.

Framsted pointed out that small-cap companies could be well-positioned to benefit from a COVID-19 economic recovery. During downturns, small stocks typically underperformed, partially because small stocks often have fewer buffers to survive economic shocks. However, smaller companies have rewarded investors for their higher risk over full market cycles. Furthermore, the size factor may be a particularly useful investment in the current economic climate since it has typically outperformed during the recovery period of an economic cycle relative to other factors.

Thinking Small

The size factor focuses on smaller companies outperforming larger ones, and there are many ways to gain this exposure, Framsted added. For example, investors can directly invest in small cap companies through funds that seek to track popular benchmarks such as the S&P SmallCap 600.

Investors can also take a look at the MSCI USA Low Size Index, which allocates more weight to smaller companies within a large and mid-cap universe. This index provides exposure to the size factor while maintaining some exposure to FAANGM, and provides investors with a way to access the larger-cap portion of the U.S. market while dissipating some of the concentration risk associated with big tech, according to Farmsted.

“Research suggests that accessing the U.S. market through this size factor lens could lead to outperformance over time,” Farmsted said.

For some investors allocating directly to small caps, the iShares Core S&P Small-Cap ETF (NYSEArca: IJR), which tracks the S&P SmallCap 600, could provide the size focus they are looking for as the economy recovers. For others who may be looking for a less concentrated approach to the large-cap universe, the iShares MSCI USA Size Factor ETF (SIZE), which tracks the MSCI USA Low Size Index, provides investors with size exposure by creating a more balanced approach to larger-cap investing.

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