RMT - IWC: Passive Investing Lags In Microcaps

2023-12-11 01:32:37 ET

Summary

• Microcap investing can lead to extraordinary returns, but retail investors are at a disadvantage due to lack of information and coverage.
• The iShares Micro-Cap ETF suffers from this information disadvantage and has modest long-term returns.
• Investors should seek professional advice from experts like the Royce Micro-Cap Trust, which has outperformed the IWC ETF on all time frames.

Microcap investing can sometimes lead to extraordinary returns. Who doesn't want to buy Monster Beverage ( MNST ) when it was a microcap company trading at a split adjusted $0.04 (Figure 1)?

However, retail investors are at a fundamental information disadvantage when it comes to microcap stocks as the many companies in this market cap range do not have analyst coverage and often have unproven products and revenues. Even buying an index of microcaps via a passive ETF like the iShares Micro-Cap ETF ( IWC ) does not help, as the winners are few and far between, leading to modest long-term returns for an index fund.

Instead, I believe investors should seek out professional advice from experts like the Royce Micro-Cap Trust ( RMT ), who have been investing in this space for over 30 years. The RMT fund has outperformed the IWC ETF on all time frames by applying a rigorous value investing process to pick micro-cap stocks trading below their intrinsic values.

Fund Overview

The iShares Micro-Cap ETF seeks to track the investment results of an index composed of micro-capitalization U.S. equities. Micro-capitalization stocks typically refer to companies with market capitalization of $50 to $300 million. These stocks tend to have greater volatility and are riskier than larger-cap stocks. With limited analyst coverage and institutional following, micro-cap stocks usually require investors to do their own due diligence to avoid fraudulent stocks or distressed businesses.

The IWC ETF tracks the Russell Microcap Index ("Index"), an index composed of the 1,000 smallest constituents of the Russell 3000 Index plus 1,000 of the next smallest issuers in the equity universe as determined by Russell. The IWC ETF uses representative sampling to track the underlying index and thus does not fully replicate the securities and weights of the index.

The IWC ETF has $841 million in assets and charges a 0.60% management fee (Figure 2).

Portfolio Holdings

As discussed above, IWC's portfolio does not fully replicate the underlying index. Currently, the IWC ETF holds 1,516 securities in its portfolio (Figure 3).

The IWC ETF is heavily exposed to the Financial and Health Care sectors that represent 24.4% and 22.0% of the ETF, respectively. Industrials (13.4%), Consumer Discretionary (10.3%), and Information Technology (10.3%) round out the top 5 sector weights (Figure 4).

The IWC ETF is broadly diversified with the top 10 holdings accounting for only 6.7% of the portfolio, even after the top holding, ImmunoGen ( IMGN ), gained more than 80% in the past month due to a takeover by AbbVie ( ABBV ) (Figure 5).

Returns

Historically, the IWC ETF has only delivered very modest returns, with 3/5/10/15 year average annual returns of -1.6%/2.8%/4.5%/9.7%, respectively (Figure 6). Since the ETF's inception in 2005, the IWC ETF has delivered average annual returns of only 5.1%.

This compares poorly to the equity markets overall, as represented by the SPDR S&P 500 ETF Trust ( SPY ), which has delivered much higher average annual returns of 9.7%/12.4%/11.7%/13.6%, respectively (Figure 7).

Micro-cap Investing Benefits From Expert Advice

When it comes to micro-cap investing, investors are generally at a large information disadvantage compared to professional investors. First, as mentioned above, companies that qualify as micro-caps tend to have little research coverage as there is little investment banking interest from the large brokerages. So investors must do their own due diligence on the companies' businesses and financials.

Furthermore, as micro-cap companies tend to have unproven products, no solid history, assets, sales, or operations, their stock price movements can experience large volatilities that may 'shake out' retail investors without strong research conviction.

Therefore, when it comes to micro-cap investing, I believe investors should hire professionals to help them build the best portfolios, instead of doing it themselves or buying simple index products.

One team of professionals I have long admired and would recommend is the Royce Micro-Cap Trust. The RMT fund is a closed-end fund ("CEF") led by Chuck Royce , the renowned small- and micro-cap investing pioneer that applies a value-investing approach to pick stocks trading at less than their intrinsic value.

Impressively, RMT has outperformed its index by being incrementally better year-in and year-out, especially during the inevitable bear markets when many 'star managers' are wiped out when their fad goes out of fashion (Figure 8).

RMT Outperforms IWC On All Time Frames

Comparing between the trailing returns of the RMT fund and the IWC ETF, there really is no contest. The RMT fund vastly outperforms IWC on a 1 year (Figure 9), 3 year (Figure 10), 5 year (Figure 11), and 10 year (Figure 12) time horizon.

For anyone interested in adding micro-cap stocks to diversify their portfolios, I would recommend they seek out professional managers like the Royce Micro-Cap Trust with a superior long-term track record of outperformance.

I last wrote about the RMT fund here .

Conclusion

The iShares Micro-Cap ETF provides broad exposure to micro-cap stocks that may deliver extraordinary returns and help investors diversify their portfolios.

However, given the inherent information disadvantage in micro-cap investing, I believe investors looking to invest in the space should seek the expertise of professional investors like the Royce Micro-Cap Trust instead of buying a passive ETF like the IWC. The RMT fund has vastly outperformed the IWC ETF on all time frames by applying a time-tested value investing approach.

For further details see: