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INVESTING IN SMALL-CAPS? ALL YOU NEED TO KNOW ABOUT ADVISORSHARES DORSEY WRIGHT
SMALL COMPANY ETF



Monday June 12

By Tony Dong · Small Cap

DWMC offers advisors a way to target the size factor premium to a deeper degree.

Small-cap ETFs have long since captivated many advisors looking for ways to
outperform a traditional market cap-weighted index. As one of the five
Fama-French risk factors, size (SMB, or Small Minus Big) suggests that smaller
companies, on average, have higher expected returns than larger companies.

Small-cap stocks (those under $2 billion in market capitalization) are often
less followed by analysts, hence their stock prices have a higher chance of not
fully reflecting all publicly available information. This lack of efficiency can
provide more opportunities for mispricing, which investors can exploit.

Moreover, many institutional investors and funds cannot invest in small-cap
stocks due to liquidity concerns and investment mandate restrictions. Therefore,
there's less competition, which can lead to greater opportunities for individual
investors.

Finally, there's the growth potential to consider. Small caps are often seen as
"publicly accessible unicorns". They can provide a unique platform for retail
investors to be part of a company's growth journey from an early stage, a
privilege often exclusive to institutional private equity investors.

When it comes to a small-cap tilt, advisors have no shortage of ETFs tracking
popular indexes like the Russell 2000 or the S&P 600. However, one ETF that
caught my attention recently for its focus on what I call "deep size" stocks is
the AdvisorShares Dorsey Wright Small Company ETF (DWMC). 

This ETF stretches beyond a small-cap focus to also target micro-cap stocks
using a unique momentum-based, active management strategy. Let's break this ETF
down and see what it’s all about. 


DWMC EXPLAINED

DWMC is an actively managed ETF that targets micro- and small-cap companies
listed on an exchange, screened for sufficient liquidity and a market
capitalization of under $2 billion. The ETF employs a momentum-based strategy
called "relative strength investing".

Relative strength, in this context, is a momentum investing strategy that
involves buying securities that have outperformed others in its universe and
holding onto them until they exhibit sell signals. 

"We use a momentum-based process to identify what securities to add and remove
from the portfolio, an investment factor that has withstood the test of time,"
says John Lewis, CMT and senior portfolio manager at Nasdaq Dorsey Wright. "We
buy securities that have demonstrated the ability to outperform the other
companies in the universe on a price return basis, and when stocks weaken and
fall in our ranks they are sold, while we look for a stronger company to add."

DWMC's proprietary approach to this is systematic, meaning that it does not
consider company fundamental data such as earnings, book value, or debt levels.
Instead, it solely focuses on the price performance of the securities relative
to others using various technical signals. 

In terms of stock selection, DWMC's approach prioritizes the highest-ranked
securities as per the relative strength investment methodology. The ranking is
based on the comparison of their price performance against other stocks in the
available investment universe.

"This approach allows us to constantly push the portfolio toward strength,"
Lewis says. "It is the classic case of watering the flowers and pulling the
weeds, as we allow the winners to run as long as they continue to perform well
and try to cut our losses quickly."

The primary advantage of this approach is the removal of emotional biases from
the investment decision-making process. Instead of being swayed by market
sentiment or other psychological factors, decisions are based on a predefined
and consistent process. 

In essence, DWMC's strategy is all about riding the momentum of the
best-performing stocks, while systematically and dispassionately shedding
holdings that are not performing as well, potentially allowing for improved
performance and risk management within a portfolio.


POTENTIAL BENEFITS OF DWMC

A key advantage of DWMC lies in its active management strategy. Contrary to most
small-cap ETFs that passively invest by tracking a benchmark index, DWMC’s
portfolio manager systematically screens small and microcap stocks for inclusion
and removal from its highly selective, active portfolio. 

This process helps limit exposure to securities identified as having
unattractive investing attributes. For a historical example of this, consider
this paper titled "Size Matters, If You Control Your Junk" from Cliff Asness,
where he argues that the size premium is most effective when quality is also
screened for. 

"Active management works very well in the microcap space, as there is a
tremendous amount of return dispersion in the universe, which means there are a
lot of big winners and a lot of big losers," Lewis says. "An active strategy
allows you to use the return dispersion to your advantage, while a passive
strategy just owns everything, including the large losers."

Given the high volatility of small and microcap stocks, limiting losses and
drawdowns becomes key to ensuring competitive risk-adjusted returns. While an
index is subject to all the downside risk, an actively managed ETF like DWMC can
tactically adjust to cut losses before they cause a large impact. 

In this respect, DWMC features guide rails to ensure sufficient diversification.
If the weight of a particular holding becomes disproportionately large in the
ETF's portfolio, it is trimmed to align better with the other security weights,
which ensures a balanced allocation. 

"The most important part of our risk management process is our objective sell
discipline - if you are going to invest in very small companies, they are not
all going to work out," Lewis says. "You will have plenty of losers to go along
with the winners, so having an objective sell discipline to trim losers from the
portfolio helps limit the damage to the overall portfolio from a single
company."


HISTORICAL PERFORMANCE OF DWMC

This approach has paid off strongly since DWMC's inception in July 2018. From
then until May 31st 2023, DWMC has outperformed two of the more notable
index-based U.S. small-cap ETFs, the iShares Russell 2000 ETF (IWM) and the
Vanguard S&P Small-Cap 600 ETF (VIOO) respectively, even after accounting for
its higher net expense ratio of 1.25%.



Source: Portfolio Visualizer

Financial advisors seeking a significant tilt towards the size factor may find
DWMC an appealing choice. After running a factor regression using a 36-month
roll period and monthly returns, I found that DWMC also possessed a much higher
loading to the size factor compared to both IWM and VIOO. 



Source: Portfolio Visualizer

In essence, this means DWMC has historically provided a stronger exposure to
smaller companies, which could lead to higher potential returns, albeit possibly
with higher risk. For advisors looking for a sizable tilt to small and microcap
stocks, but without the weaknesses of an index, DWMC could be a viable option. 

Looking to understand which funds in your portfolio have micro-/small-cap
exposure, and to what degree? Fundinsight can help you with its exposure check
tool, among many other features. Register an account and login here (it’s free!)

The views and opinions expressed herein are the views and opinions of the author
and do not necessarily reflect those of Nasdaq, Inc. or Trackinsight. Past
performance is not indicative of future results. Investors should undertake
their own due diligence and carefully evaluate companies before investing.
ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.

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