ETF Investing: Small-cap ETFs tax investors with big losses

By John Spence, MarketWatch

BOSTON (MarketWatch) — This year so far, small-cap stocks are no
longer the market's big winners.

Exchange-traded funds that target U.S. small-capitalization stocks
have fared much worse than big, blue-chip shares during last week's
pause after leading the market during the rally.

The iShares Russell 2000 Index Fund
 , which follows a popular small-cap index, closed the week
with a roughly 4% loss, lagging the SPDR S&P 500 ETF

!! Big Stocks Are Better !!

Smaller and riskier stocks have led this bull market, and that's
reason to be cautious about them, says Nick Tompras, chief investment
officer at money manager Alpine Capital Research. MarketWatch's
Jonathan Burton reports.

That's a sharp turnabout from past performance. The $16.7 billion
small-cap ETF rallied 26.9% in 2010, nearly doubling the 14.4% gain
turned in by the S&P 500 fund.

"Small-cap stocks had enormous outperformance against large caps
that was way out of whack with historical norms," said Michael
Gayed, chief investment strategist at Pension Partners LLC,

"If we get a bigger correction, that could unwind some of the froth
and the outperformance spread relative to large caps," he added.

Additionally, weakness in small-cap indexes damages breadth indicators
because they contain more stocks, which would be a negative sign for
overall market sentiment, Gayed said.


Slow And Unsteady


Small-cap growth portfolios in particular, such as Vanguard Small Cap
Growth ETF
, have been showing signs of fatigue. Some analysts
use the main style classifications of growth and value stocks when
examining market trends.

Part of the recent weakness of small-cap growth ETFs is related to
their sector allocations, with heavier tilts to consumer discretionary
and technology stocks, analysts noted. The two sectors were among the
market's strongest in 2010.

Overall, the market's smaller stocks tend to outperform in the early
stages of a bull market, so analysts are looking for any signs of
slippage from the group.

From a technical perspective, OptionMonster contributor Bryan
McCormick said he's watching to see what happens with small-cap ETFs
at their 50-day moving average. Last week's slump brought them close
to this indicator.

"It's not atypical to see tests of the 50-day in bull markets,"
the independent analyst said. "If there is a bounce there people
will quickly forget about this correction."

The iShares Russell 2000 has stumbled into 2011 with a negative
year-to-date return.

Small-cap stocks tend to be more volatile than shares of bigger,
more-established companies. They also derive less revenue from
overseas compared with large-cap multinationals.

Small-cap stocks represent just about 7% of the stock market "so
they should be only a small part of a passive investor's
portfolio," said Michael Rawson at Morningstar Inc. in a recent
analyst report on the ETF.

U.S. small caps have historically provided some diversification
benefits, Rawson said.

He listed Schwab U.S. Small-Cap ETF
 , Vanguard Small Cap ETF
 and iShares S&P SmallCap 600 Index Fund
 as other ETF options for small caps.

John Spence is a reporter for MarketWatch in Boston.

Source: Marketwatch.Com