Small-Cap Investment Choices for a Dividend Portfolio

Written by The Dividend Guy on October 14, 2007

Small-Cap Investment Choices for a Dividend Portfolio

Approximately a week ago I wrote a post about whether small-cap stocks have a place in a dividend investing portfolio. I concluded that based on the overall historical performance of small-caps, and the fact that investment returns are primarily driven by asset allocation as opposed to individual stocks, small-caps do indeed have a place in my portfolio. In this post I want to take the discussion to the next level and discuss ways a dividend investor can invest in small-caps, and choose how I am going to integrate small-caps into my own portfolio.

The way I see it, there are essentially 3 ways a dividend investor can buy small-cap stocks for their portfolio. They are buying individual small-cap stocks, buying mutual funds with a focus on small-caps, or buying an ETFs that are allocated solely to small-caps. I would like to discuss each one.

Buying Individual Small-Cap Stocks

The first option for dividend investors looking for small-cap exposure is obviously identifying, researching, and buying individual small-cap stocks. Given that the standard deviation on small-caps is high (i.e. they are more volatile than large-cap stocks), it would be more prudent to hold a basket of small-cap stocks to limit volatility and to balance risk. A recent book I have read, The New Rules for Investing Now: Smart Portfolios for the Next Fifteen Years, suggests that investors hold at a minimum 25 small-caps to manage risk. Given my time and the fact that researching my large-cap dividend stocks takes as much time as it does, I don’t think I have the time to dedicate to finding and keeping track of 25 additional stocks. Individual small-cap stocks are out of the question for me.

Small-Cap Mutual Funds

Doing a quick search on Globefund for small-cap mutual funds, it appears that in Canada alone there are 86 small-cap funds available. Given my propensity to avoid mutual funds like the plague because of high fees, I sorted the results table by MER and saw that the range of fees ran from a low of 0.14% to a high of 3.96%. The funny thing about the low fee fund was that it required a $150,000 minimum investment. The most expensive fund, available from Manulife Financial, has not beaten the Russell 2000 index once since its inception. So much for getting what you pay for! Just to be fair and out of my own personal interest, I also looked at a middle of the road fund with a more reasonable MER of 2.38% from Fidelity and saw that this fund did not beat the index as well. I am going to pass on buying small-cap mutual funds because of these fees and performance against the indexes.

Small-Cap ETFs

This leaves me with my final option - to invest in a small-cap focused ETF or index fund that provides exposure to a lot of small-cap stocks at a low fee. As most PF bloggers know, ETF and index funds tend to pay low fees and while providing investors with diversification - if you are in doubt then be sure to check out Free Money Finance’s article on ETF 101: 5 Reasons ETFs Trump Mutual Funds. So what are my options for investing in a small-cap ETF? I did some digging around and have identified these as small-cap ETFs that may be an option for investors - keep in mind that I was not too focused on dividend paying small-caps as I wanted to get exposure to the whole small-cap market and not just a sub-set of it:

ETF MER Profile
WisdomTree SmallCap Dividend Fund 0.38% The WisdomTree SmallCap Dividend Index is a fundamentally weighted index measuring the performance of the small-capitalization segment of the US dividend-paying market. The Index is comprised of the companies that compose the bottom 25% of the market capitalization of the WisdomTree Dividend Index after the 300 largest companies have been removed (thanks to Troy R for putting me on to this one)
iShares Russell 2000 Index Fund 0.20% The iShares Russell 2000 Index Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the small capitalization sector of the U.S. equity market as represented by the Russell 2000 Index. The index represents the approximately 2,000 smallest companies in the Russell 3000 Index.
iShares S&P SmallCap 600 Index Fund 0.20% The iShares S&P SmallCap 600 Index Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of U.S. small-cap stocks, as represented by the Standard & Poor’s SmallCap 600 Index.
Vanguard Small-Cap ETF 0.10% Vanguard® Small-Cap ETF seeks to track the performance of a benchmark index that measures the investment return of small-capitalization stocks.

These, in my opinion, would all be interesting picks. Again, I am focused on getting exposure to a number of small-cap stocks so I am not necessarily looking for small-cap dividend stocks here, but it appears that these funds do distribute their dividends so one would get that benefit as well. Before I make my decision, I will need to do some more analysis on these funds to pick the right one. That will be a topic of a future post!


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5 Comments so far

  1. Investing » Small-Cap Investment Choices for a Dividend Portfolio October 14, 2007 10:46 am

    […] Sun wrote an interesting post today onHere’s a quick excerptThe funny thing about the low fee fund was that it required a $150000 minimum investment. The most expensive fund, available from Manulife Financial, has not beaten the Russell 2000 index once since its inception. … […]

  2. Troy R October 14, 2007 1:55 pm

    Here is another idea for small cap exposure without sacrificing dividends, PowerShares High Yield Dividend Achievers (ticker: PEY). This ETF is really 50% small to micro cap, 25% mid cap and 25% large cap. Its yielding a nice 4.11% for what amounts to a small cap portfolio. Its yield and small cap weighting are satisfying enough but even better is the 15 year “credit rating” you get with the Dividend Achievers Index. The down side is a oddly large .5% expense ratio. I see no reason why such a portfolio should have such large expenses.

  3. Troy R October 14, 2007 2:12 pm

    I see high yielding dividend funds as having some serious advantages. For starters you get all the advantages of both market anomalies, high yielding stocks AND small cap stocks. Second, almost by definition you are getting small cap value stocks when you get high yield. Really what you get is akin to a small cap ultra deep value stock. But why get “small cap mild yield” when you can have large yield for about the same expense costs? In terms of risk I see many advantages. Most of us are aware that dividends give a natural floor to the stock, they cushion abnormally steep declines. Second, I see high price volatility as a good thing for small cap high yielders because as the price swings I have more opportunities to reinvest my dividend at lower prices. The price oscillations allow me the opportunity to more deeply “compound” my dividend reinvestment thereby giving me more return on the upside. You might ask, ‘don’t the ups and downs cancel each other out?’ Good question and I don’t really know the answer. I’m working on testing that now but I have a hunch that volatility is a good thing for high yielders.

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  5. Weekly Dividend Investing Roundup - November 23, 2007 November 23, 2007 8:53 am

    […] has some dividend based ETF’s that may be worth a look. I looked at WisdomTree’s small-cap offering awhile […]

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