Could Your Portfolio Benefit from Small-Caps?

A look at how adding equity exposure at the low end of the market capitalisation spectrum could potentially benefit a balanced portfolio

Morningstar ETF Analysts 22 September, 2010 | 3:17PM
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One of the greatest features of exchange-traded funds is their ability to slice the market up into different sections. We’ve highlighted sector ETFs (utilities, insurance, travel and leisure, banks), single-country ETFs (South Africa, the United States, Spain), different asset classes (hedge funds, commodities), and fundamental and dividend ETFs, but you can also divide equities into the market capitalisations of the companies included in an index. Individually, smaller companies tend to be riskier, but they also offer a greater reward potential, so by using an ETF to gain exposure to the sector you can reduce stock-specific risk while diversifying your portfolio and theoretically earn higher returns.

The benefits of adding small-capitalisation equity exposure to a portfolio have most famously been highlighted by Eugene Fama and Kevin French in their 1992 paper, "The Cross-Section of Expected Stock Returns". They examined the returns of US stocks from 1963 through 1990 and discovered that the returns could be explained by three factors; beta, size and price-to-book (or value). Ignoring the beta and price-to-book factors for this article, the findings showed that historically small-cap stocks outperformed their large-cap brethren, even after adjusting for risk. Subsequent research found that these results hold true in the United Kingdom, throughout Europe and Asia, and in other time periods within the United States.

So how can you harness the benefits of small-cap exposure into your own portfolio? In our monthly webinar series, we've highlighted how to build a core portfolio with ETFs. We built a hypothetical low-cost portfolio using ETFs with a 60/40 split between equities and fixed-income exposure.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure.