Small-cap stocks have been on a solid run in 2021. In particular, small-cap value stocks have delivered strong performance relative to small-cap growth stocks, perhaps as investors have shifted preferences in favor of companies with steady earnings and relatively modest valuation multiples.

Investing in small-cap stocks can be challenging – the universe of available companies’ numbers in the thousands, and most of them are companies retail investors have never heard of. The top three holdings in the Zacks Small Cap Equity Strategy as of Q2 2021, for example, are Moelis & Co, Boot Barn, and Generac Holdings. Depending on where you live, none of these companies may ring a bell. It’s for that reason many investors turn to exchange-traded funds (ETFs) in order to gain exposure to the small-cap category.1

I generally do not have an issue with ETFs as an investment option. They can offer investors low-cost access to a diversified portfolio of assets, which is especially useful for someone just starting out. ETFs make less sense with higher net worth investors, in my view, because owning the index means taking the good with the bad, instead of using empirical research and a disciplined investment process to choose individual stocks that address your growth, risk, and tax objectives.

In the small-cap world, however, I see a problem with ETFs in 2021 no matter what type of investor you are. The problem: “meme stocks.”

As it relates to small-cap value as a category, AMC and GameStop have been the two biggest contributors to performance for the year, which has also vaulted them into outsized holdings in ETFs. In the iShares Russell 2000 Value ETF and the Vanguard Russell 2000 Value ETF, for example, AMC is the biggest holding. The company’s outrageous $22 billion market cap – which has been driven in large part by online fame and social media postings – makes it 14 times larger than the ETF’s average holding. That’s troublesome.

AMC’s fundamentals are murky at best, and the stock is trading at a very high multiple. Many investors may think twice about buying it, and that’s where owning a small-cap value ETF could be problematic – it means having AMC as a top holding. GameStop was dropped from the Russell 2000 value index in June, but it is also a stock many investors may not want as a primary holding in an ETF. These types of scenarios expose issues with the passive index ETF approach. Sometimes you end up owning stocks you don’t want.

I’m not making the case for or against GameStop and AMC. They just do not currently meet the research-driven, fundamental criteria we use to inform our decision-making at Zacks Investment Management. We start with the entire universe of small-cap names (which includes growth and value stocks), run each company through a proprietary quantitative screen, weigh the risk-adjusted return potential, and then monitor the top 100 or so stocks regularly to ensure they keep meeting our criteria. We do not choose stocks based on online trends or viral videos, and stocks with declining fundamentals are promptly sold.

Bottom Line for Investors

As I mentioned in this column, I do not take issue with ETFs in general. They can be useful for many types of investors to gain diversified exposure to an investment category – like small-cap stocks – at a low cost.

But it’s important to understand the rules and guidelines informing how an ETF is constructed, which could ultimately mean you end up owning stocks with poor fundamentals. Investors who are truly value-oriented and focused on fundamentals would not be satisfied with that outcome. An actively managed approach, like we have at Zacks Investment Management, means taking greater care to know exactly what is in your portfolio, and what isn’t.

Disclosure

*This information is supplemental to GIPS and is based off the composite
**The standard deviation shown here is calculated since inception

1 Wall Street Journal. September 13, 2021. https://www.wsj.com/articles/meme-stocks-amc-and-gamestop-push-small-cap-benchmark-higher-11631525580

2 Zacks Investment Management. Q2 2021. Small Cap Equity Strategy.

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