A micro-cap index and ETF planned

Jun 20, 2005 @ 12:01 am

By David Hoffman

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NEW YORK - Friday's public debut of the Russell Microcap Index and the pending launch of an exchange traded fund based on the index later this year may pave the way for other companies, industry experts say.

There are relatively few micro-cap mutual funds and no micro-cap ETFs. Research by Lipper Inc. showed that just 87 share classes of mutual funds identified themselves as micro-caps in their prospectuses.

Neither New York-based Lipper nor Morningstar Inc. in Chicago breaks micro-cap funds out as a separate fund category.

But the fact that one of the best-known names in indexing, Frank Russell Co. in Tacoma, Wash., which operates as the Russell Investment Group, is coming out with an index that tracks the category could help change that, some industry observers say.

There are at least two other indexes - the MSCI US Micro Cap Index, developed by Morgan Stanley Capital International Inc. in New York, and the Wilshire Micro-Cap Index, developed by Wilshire Associates Inc. in Santa Monica, Calif. But financial advisers said that those indexes aren't as widely followed as Russell's.

Greater transparency could result from Russell's move into micro-caps.

"A lot of [micro-cap] companies are not followed by Wall Street," said Tom Orecchio, a principal with Greenbaum & Orecchio Inc. in Old Tappan, N.J., a financial advisory firm with $200 million under management. "There will clearly be some firms that garner more attention than they did in the past."

That could make it easier for mutual funds and ETFs to invest in micro-caps, said Laura Lutton, an analyst with Morningstar.

Little research is available on micro-cap stocks, she said. If greater attention via an index translates into more research, it is likely that more fund and ETF providers will be willing to jump into the arena, Ms. Lutton said.

That could be a double-edged sword. On the one hand, there is demand for micro-caps.

"We try to use micro-cap funds in all our accounts," said David Cowles, director of investments for Boone Financial Advisors Inc. of San Francisco, which has $225 million under management.

There are two main reasons, he said. One is that micro-caps are relatively uncorrelated to other investments. Another is that micro-cap securities have demonstrated an ability to outperform other categories over long periods.

On the other hand, if more investors start to pay attention to micro-caps, the fundamentals underlying the category could change, industry experts say.

The micro-cap market is relatively inefficient, characterized not only by a lack of research but also by very little liquidity.

There is a possibility that the new index, along with the proposed ETF, could lead to greater liquidity, according to Lori Richards, a senior product manager at Russell.

But it shouldn't greatly affect the way the market behaves, she said, or the ability of active managers to find value in the market.

Michael Corbett, president of Perritt Capital Management Inc. in Chicago and manager of the $270 million Perritt MicroCap Opportunities Fund, said the market will continue to be relatively illiquid.

As a result, he said, he doubts that there will be more research on micro-cap funds, because it is just too difficult for a sell-side firm to do enough business in micro-caps to justify the research effort.

But at least one adviser said he is excited about the prospect of a widely followed index that tracks the micro-cap universe.

Mr. Cowles said he is already interested in the ETF that will be based on the Russell Microcap Index.

Cutting costs

Barclays Global Investors of San Francisco filed papers this month with the Securities and Exchange Commission to offer the ETF.

One adviser who uses micro-cap funds said the new ETF could change the way he invests in micro-caps, because such funds generally have relatively high expenses. But an ETF presumably would come at a lower cost, said Russell Wild, principal of Global Portfolios in Allentown, Pa., a financial advisory company that works on an hourly basis and doesn't have assets under management.

He said he uses the Perritt MicroCap Opportunities Fund, which has an expense ratio of 1.25%, but would expect the Barclays ETF to have an expense ratio of at least 0.5 percentage points less.

That doesn't mean Mr. Wild would recommend his clients sell all their holdings in the Perritt fund. Its average market cap is $197 million, while the average market cap of the Russell Microcap Index is expected to be about $290 million, he said.

Like many advisers who champion micro-caps, Mr. Wild thinks the smaller, the better. He said he could foresee owning a little bit of both the Perritt fund and the proposed ETF.

One adviser said he is leery of the attention micro-caps are garnering.

"The area has really taken off," said David Fernandez, founder and president of Wealth Engineering LLC of Scottsdale, Ariz., a financial advisory firm with $17 million under management. "With that much money chasing such a small area, no one knows for sure what's going to happen to it."

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