ETFs That Buy Small-Caps Have Good Timing

NEW YORK (TheStreet) -- Exchange traded funds have become ever more narrow.

ETFs sliced into sectors offer the chance for better risk-adjusted returns, even as some say niche funds are unnecessary. Industry ETFs enable investors to diversify their portfolios.

PowerShares recently opened a door for people interested in creating more nuanced portfolios with a bevy of small-cap industry ETFs: PowerShares S&P SmallCap Consumer Discretionary Portfolio(XLYS), PowerShares S&P SmallCap Consumer Staples Portfolio(XLPS), PowerShares S&P SmallCap Consumer Staples Portfolio(XLES), PowerShares S&P SmallCap Financials Portfolio(XLFS), PowerShares S&P SmallCap Health Care Portfolio(XLVS), PowerShares S&P SmallCap Industrials Portfolio(XLIS), PowerShares S&P SmallCap Information Technology Portfolio(XLKS), PowerShares S&P SmallCap Materials Portfolio(XLBS) and PowerShares S&P SmallCap Utilities Portfolio(XLUS).

PowerShares' strategy is to essentially copy the concept that SPDR has used in dividing the S&P 500 Index into sector ETFs using every stock. For the small-cap ETFs, PowerShares has broken out the S&P 600 Small Cap Index into nine industry funds. Some exchange traded funds, such as discretionary and technology, have more than 100 holdings, and others as few as 20.

As bull markets begin, small-cap stocks tend to outperform. As the rally matures, blue chips take over. Investors who think the rally that started in March 2009 is a new secular bull market would want to favor small caps over large caps. Those who say the current rally is stuck in a secular bear market would likely lean the other way and perhaps pair a short sale of a small-cap sector ETF with a long position in a large-cap industry fund.

As with any ETF or family of ETFs, it's important to look under the hood to know how the funds are constructed. For example, the Small Cap Financial Portfolio has a much larger weighting in real estate investment trusts, or REITs, than its large-cap cousin -- six of the top 10 stocks, in fact. It wouldn't make sense to buy the Small Cap Financial Portfolio if you're in the camp that says commercial real estate is the next shoe to drop.

The Small Cap Energy Portfolio is one of the quirkier funds in the group. It has only 23 holdings, so some of the names like St. Mary's Exploration(SM), Oil States International(OIS) and Dril-Quip(DRQ) are weighted at over 8% of the fund.