We're Adding An ETF To Our Portfolio: Invesco S&P Small Cap 600 Quality ETF (XSHQ)

Tues, 16 Nov 2021 8:00 AM EST

What Is An ETF? (Source: NerdWallet)

An exchange-traded fund, or ETF, is a fund that can be bought and sold on an exchange like a stock. An ETF works like this: the fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors. Shareholders own a portion of an ETF, but they don’t own the underlying assets in the fund. While ETFs are designed to track the value of an underlying asset or index, they trade at market-determined prices that usually differ from that asset. 

ETF Benefits - Diversification For Less Due Diligence (Source: Forbes)

We like to say that for each stock you own, you want to spend an hour per week to do research and active management. 24 hours a day, 7 days a week of research and that caps the number of stocks you can own to 168. What if you want to diversify your portfolio by owning a basket of stocks with the same theme, without having to actively manage all of them? The answer is ETF. Put your money in a fund that manages those stocks that you want to own. Because the impact and importance of any one stock is relatively small, you can spend your time thinking about which sectors and markets are poised to perform and make investment choices without being bogged down by an overwhelming amount of initial and ongoing due diligence to pick individual stocks. On the US market, there are many ETFs which own baskets of stocks. For example, the SPDR S&P 500 ETF (SPY) is a fund that tracks the S&P500 Index, containing 500 biggest public companies in America; so rather than owning all 500 companies, you can own SPY shares. The benefit here is that if one company in the S&P500 doesn't perform well, the remaining 499 can perform well and still can deliver returns (example: Boeing is only up 9% this year, while the S&P500 is up 26%). On the flip side, SPY can underperform relative to individual stocks (example: Ford is up 133% this year, while the S&P500 is up 26%).  

Small Market-Capitalization Stocks - An Economically Sensitive Bet

The U.S. economy is expected to expand at a fairly fast clip next year. The consensus estimate from economists is that the U.S. will see real gross-domestic-product growth of 4% in 2022, above the below 2% rate typically seen before the pandemic, according to Wolfe Research. That’s largely because households have so much excess cash they have built up from economic stimulus and returning to work that they won’t be able to spend all of it this year. The expected growth has acted as a shot in the arm for small-cap stocks. The earnings of smaller companies are more sensitive to changes in the economy.

But risks to economic growth have recently been more pronounced. High inflation, if proven persistent, could dampen economic demand. Meanwhile, the Federal Reserve is seen by many as "behind the curve" on rate hikes, and may have to lift interest rates aggressively to combat inflation. These two stones thrown at the economy will certainly hurt the economy, eventually leading to lower growth while raging inflation, a phenomenon referred to as stagflation.

Why Quality Small Cap Stocks?

That dynamic (or risk, rather) makes small-cap quality stocks an attractive deal for us. Small caps have the potential for high returns, yet quality ones pose less risk than lesser-quality small-caps. On the market, we have the S&P SmallCap 600 Quality Index which measures 120 highest-quality stocks in the S&P SmallCap 600 on the basis of their quality score, which is calculated using three fundamental measures: return on equity, accruals ratio, and financial leverage ratio. 

The quality element means investors don’t have to take much extra risk. If the Fed raises rates and the cost of borrowing increases, quality companies can still borrow without seeing their interest rates jump too high. That’s a key factor that helps keep a company’s valuation elevated. That, in turn, reduces the stock’s volatility. “We think small-cap investors have the rare opportunity to pay an almost immaterial premium to move up in Quality—a style that thrives during market stress and/or a slower growth environment,” writes Christopher Harvey, head of equity strategy at Wells Fargo.

The valuation side looks attractive, as the S&P SmallCap 600 is trading at 16 times forward earnings, compared to the 21.5 multiple of the S&P500 Large Cap (see charts below).    

Invesco S&P SmallCap Quality ETF (XSHQ) 

The Invesco S&P SmallCap Quality ETF (XSHQ) closely tracks the S&P SmallCap 600 Quality index. The fund will invest at least 90% of its total assets in stocks that comprise the index. Again, since there is the term "quality" there are not 600 stocks in this index, but rather only 120 stocks. Work has been done by index management team to apply three fundamental measures and select out those 120 small-cap stocks: return on equity, accruals ratio and financial leverage ratio.