Some investment professionals discourage investment in penny stocks claiming it's almost always a bad idea for serious investors. Some have earned significant returns through penny stocks, but the majority don't see a big difference in the overall portfolio. While there are disagreements over the wisdom of investing in low-cap stocks, what about penny stock ETFs? Is there even such a thing? The answer is yes, but they're referred to as low cap ETFs.
What are Penny ETFs?
Exchange-Traded Funds are alternative investment strategies to direct stock investments. They give investors exposures to specified markets while minimizing the risk of loss. Penny stocks are also known as small-cap or microcap stocks. These stocks are common shares of public companies that trade at low share prices. The ETFs that follow indexes correlated with microcap stocks are penny funds.
Risks of investing in Penny ETFs
Most penny stock companies are small and they might not even be listed on the main exchanges. Some are traded over the counter and are referred to as OTC, according to Public. Penny stocks are considered a risky investment because of the low trading volume and most are offered by small companies that are still developing. Penny ETFs are used as a strategy for investment portfolio diversification and they are attractive because of the low investment costs.
How to choose the right Penny ETFs
Microcap ETFs are an alternative to direct investment in penny stocks, but as with any investment, there are associated risks to consider. It's wise to investigate the fees associated with the fund before you invest, as well as considering the minimum investment required to purchase these ETFs. It pays to find out as much about the fund and its investment strategies as you can. You may ask about the duration of the contracts, the liquidity of the fund, net assets, and information about the index that the ETF tracks.
Microcap ETFs for consideration
Investopedia highlights three microcap ETFs that offer consistent daily trading volumes, stable net asset bases, and reasonable liquidity. We view these funds as the best bets coming to the end of 2020, at least for the short term, possibly longer investment options.
AdvisorShares Dorsey Wright Microcap ETF (DWMC)
We like the diversity of DWMC's investment strategy that includes Five 9, Inc comprised of 159 funds for greater portfolio diversity and a healthy risk spread from the lower portion of the Russell 2000 Index combined with other penny stocks. The majority of the holdings for the fund exist within the financial and technology sectors at 21%. The next largest investment concentration lies within the industrial and healthcare industries at 13.50% and19.02%. The expense ratio of the fund is 1.25%. It's is on the high end due to the active management of the fund. The fund originated in 2018. It manages approximately $1.4 million in assets.
iShares Microcap ETF (IWC)
The iShares Russell Microcap ETF is the largest fund in its class. The total net assets of this fund are over $768.95 million. The average daily trading volume of this ETF is just under 66,000 shares with reasonable liquidity. The sector is made up mostly of individual penny stocks featuring a thin trading volume. This fund tracks the Russell Microcap Index performance using a weighting methodology of market capitalization. The expense ratio of the iShares Microcap ETF is high at 0.60%, which is 0 .16% above the average ETF expense ratio. The total number of holdings for this ETF is 1,358. The heaviest weighting is in the health care sector stocks at 28.01%, followed by the financial sector at 22.07%, and from the information technology sector at 11.2%. The remainder of the fund consists of other holdings in diverse sectors of the penny stock market.
First Trust Dow Jones Select MicroCap Index Fund (FDM)
The First Trust Dow Jones Select Microcap Index Fund assigns weight according to market capitalization for its highest priority. The next considerations are trading volume, PE ratio, trailing price, and sales ratio, per-share profit change from the prior quarter, and operations profit margin. Finally, six-month total return. This weighting sequence is part of the methodology employed by fund managers. The fund tracks the Dow Jones Select MicroCap Index. The total net assets of the fund are approximately $79.7 million. FDM is the second-largest microcap ETF. The largest holding of the fund is Kodiak Sciences Inc at 2.59%, followed by a variety of penny stocks comprising the top 10 assets within the portfolio. The weighting places financial stock in a 32.7% ratio. This is followed by industrial at 17.93%, consumer cyclical stocks at 14.98%, health care stocks at 7.98%, with a total of 205 holdings. The expense ratio for this ETF is high at 0.60%. The average daily trading volume is thin at 4,633 shares.
While it's difficult to find an ETF that is advertised as a Penny ETF there is plenty of microcap ETFs that are in essence, the same thing. Penny stocks are popular with investors who are looking for cheap investments to diversify their portfolios, and some penny stock investments do result in a satisfactory ROI. Due to the nature of penny stocks, the risk factor is higher because many of the companies are still in their developmental stages, even after going public. There are no guarantees of success or growth/sustainability. Investing in microcap ETFs provides exposure to the penny stock market without the blatant risks associated with direct investment in new or fledgling companies that may or may not succeed. Management of exchange-traded funds does significantly lessen the risks, however. If you're thinking about investing in penny stocks, you may want to also consider the less risky strategy of investing in a microcap ETF as an alternative. The key takeaway for this type of investment is that it lets you gain exposure to the market and get your feet in the water with a bit more confidence.
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Written by Allen Lee
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