Small-cap stocks have emerged as a potentially overlooked and undervalued asset class for advisors seeking opportunities in the current market landscape. Although US small caps have historically underperformed, the outlook for this sector in the coming years looks increasingly promising.
To explore the dynamics and benefits of one standout exchange-traded fund (ETF) in this space, Wealth Advisor Managing Editor Scott Martin spoke with Mike Reidy, a Client Portfolio Manager at Principal Asset Management, about the Principal U.S. Small-Cap ETF (Nasdaq: PSC).
US small caps represent one of the most vibrant segments of the investment universe. Despite historical underperformance, current market conditions present an attractive entry point for these stocks, says Reidy.
The sector is home to a diverse, developed, and dynamic market where companies often start with visions of innovation and disruption. Household names such Apple, Nvidia, Home Depot, Starbucks, and Tesla began as small-cap companies and grew into dominant economic forces.
The macroeconomic backdrop enhances the appeal of US small caps today. Valuations, while not always indicative of short-term performance, provide long-term insights, Reidy believes. Compared to midcaps and large caps, US small caps offer more attractive valuations, making them a promising investment opportunity.
Small caps are crucial because they are the breeding ground for the giants of tomorrow. Although not all small caps will achieve trillion-dollar valuations, the next major players in the market are more likely to be found in this segment than among existing mega caps. This potential for significant growth is a compelling reason for advisors to consider small caps.
Additionally, the current economic cycle, characterized by attractive valuations, further strengthens the case for small-cap investments. Unlike the S&P 500, which often presents concerning price-to-earnings ratios, small caps offer more reasonable valuations relative to expected growth.
The Principal US Small-Cap ETF is designed to provide strategic beta exposure, with the goal of outperforming passive indices such as the Russell 2000, Reidy explains. Using a multifactor approach, PSC aims to enhance consistency in outperformance while maintaining diversification. The fund is structured to avoid unintentional sector-level risks and remain diversified with more than 500 stocks, resulting in a sector-neutral portfolio relative to the Russell 2000.
PSC uses a multifactor framework that begins with the Russell 2000 as its investment universe. The initial step involves screening out the bottom 10% of the benchmark’s market cap, eliminating the most illiquid stocks and narrowing the universe to about 1,500 stocks. The multifactor strategy then deploys more than 30 factors, categorized into three main buckets: quality, value, and momentum.
Quality factors focus on above-average profitability and pricing power. The analysis includes evaluating a company’s ability to achieve and sustain profitability and its pricing power, which indicates earnings stability and responsiveness to inflation.
Value factors are assessed from a holistic shareholder yield perspective, considering dividend yield, dividend growth, shareholder buybacks, and free cash flow yield. This comprehensive view ensures a thorough evaluation of a company’s value.
Momentum factors consider a multi-time horizon approach, favoring intermediate momentum while accounting for, but deemphasizing, long-term momentum because of its tendency to revert.
After ranking stocks based on these factors, the portfolio is refined to about 500 securities. The final step involves a calibration at the sector level, favoring more liquid and less volatile stocks while slightly disfavoring less liquid and more volatile names. This process ensures a sector-neutral ETF that accurately represents the US small cap space, Reidy explains.
The PSC ETF is rebalanced one to three times per year, he adds, with no single stock exceeding 70 basis points in weight. This approach guarantees true diversification and prevents excessive concentration in any single stock or sector.
Principal developed the US Small-Cap ETF to address a gap that its multi-asset portfolio team identified. The need for a US small-cap manager that was not capacity constrained and maintained pure exposure to US small caps led to the creation of PSC.
The fund offers high capacity and efficiency within an ETF wrapper, with a competitive management fee of 38 basis points, Reidy notes. This makes PSC a cost-effective and scalable option for advisors seeking pure US small cap exposure.
Investing based on factors can seem daunting because of the complexity and variability of factors. However, PSC’s multifactor approach is devised to simplify this process.
The focus is on screening out companies with the least potential to become future stalwarts, often referred to as “zombie companies.” These unprofitable firms can drag down portfolios during market downturns, so avoiding them provides built-in downside protection.
As Reidy points out, the Principal US Small-Cap ETF is designed to be a core allocation within the small-cap space rather than a satellite option. It is diversified and represents the entire US small-cap core space, making the fund suitable as a central component of an investment portfolio. Advisors typically allocate 25–30% of their US equity exposure to small caps, and PSC fits well as the core holding for this allocation.
PSC incorporates robust risk management strategies to enhance its appeal. The commitment to avoiding unprofitable companies and selecting firms with solid earnings stability provides downside protection during market downturns. This approach ensures that the PSC ETF can offer consistent performance while managing risks effectively.
The current market context highlights the importance of small caps. Economic recovery phases provide fertile ground for small caps to thrive, particularly those with strong fundamentals. Increased consumer spending and innovation in various sectors position small caps for significant growth. PSC is strategically designed to capture these opportunities effectively.
The Principal U.S. Small-Cap ETF represents a strategic innovation in the ETF landscape. By focusing on US small caps, the fund aims to seize the growth potential of tomorrow’s giants while benefiting from currently attractive valuations. The multifactor approach and sector-neutral construction target diversified and consistent performance, making PSC a compelling choice for advisors and investors alike.
As market dynamics continue to evolve, ETFs such as PSC offer a robust tool for navigating the complexities of small-cap investments. With its strategic design and competitive fee structure, PSC stands out as a valuable addition to the investment tool kit for those seeking growth in the small-cap arena.
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Additional Resources
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Disclosures
Carefully consider a fund's objectives, risks, charges, and expenses. For a prospectus, or summary prospectus if available, containing this and other information, visit www.PrincipalAM.com or call sales support at 800-787-1621. Please read it carefully before investing.
ALPS Distributors, Inc. is the distributor of the Principal ETFs. ALPS Distributors, Inc. and the Principal Funds are not affiliated.
Asset allocation and diversification do not ensure a profit or protect against a loss. Investing in ETFs involves risk, including possible loss of principal.
ETFs are subject to risk similar to those of stocks, including those regarding short-selling and margin account maintenance. Investor shares are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Ordinary brokerage commissions apply.
Equity investments involve greater risk, including heightened volatility, than fixed-income investments. Small-cap stocks may have additional risks including greater price volatility.
Unlike passive ETFs, there are no indices that Principal U.S. Small-Cap ETF (PSC) attempts to track or replicate. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager.
Index performance information reflects no deduction for fees, expenses, or taxes. Indices are unmanaged and individuals cannot invest directly in an index.
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