The potency of small-cap stocks under the right circumstances is undeniable. Whether it’s early in the year during a real January Effect or when the economy is just starting to show signs of emerging from a recession, small-caps have a historical tendency to outperform their large-cap brethren. But what about the even riskier cousin to small-caps, micro-cap stocks?

The standard definition of micro-cap stock, courtesy of Investopedia, is as follows: “A publicly traded company in the United States that has a market capitalization between approximately $50 million and $300 million.”

Get into that neighborhood of market cap and you’re talking about some speculative stocks that have little to no analyst coverage. That makes stock-picking in the micro-cap universe especially difficult. However, that doesn’t mean there’s not alpha to be had here. Quite the contrary. Micro-caps can be extremely rewarding…when you pick the right ones of course.

Micro-cap ETF as an Alternative Strategy

But as we just said, that’s not always easy. Well, try an ETF that’s entirely devoted to micro-caps on for size. There are several funds in this market niche to consider with one of the preferred options being the PowerShares Zacks Micro Cap ETF (NYSE: PZI). The PowerShares Zacks Micro Cap ETF has been around for over six years and finished 2011 with nearly $32 million in assets under management, which at least ensures the fund won’t be headed to the ETF Graveyard anytime soon.

In a rough year for riskier fare like small and micro-caps, PZI was off a tad more than 14%, but the fund surged almost 17% during the fourth quarter and if it can get the new year off to a good start and gain about 50 cents, it would clear its 200-day moving average and perhaps entice new buyers with its improving technical picture.

PZI is an ETF advocates of portfolio diversification can cozy up to. Currently, the ETF is home to 400 stocks spread across 10 industry groups. Four of those sectors – financials, technology, industrials and consumer discretionary – get double-digit allocations.

Two quibbles with PZI: The expense ratio is high at 0.7% and if you’re looking to avoid bank stocks, this isn’t the ETF for you as financials get a sector allocation of almost 27%. The other side of that coin is that smaller banks have easily outperformed the major money center banks for several consecutive years now.

To be sure, with a beta of 1.32, PZI is not an ETF you want to recommend for your grandfather, but the fund is useful on two fronts. As we have already mentioned, PZI alleviates the burden of stock-picking in a universe where that endeavor can often be less than pleasant. Next, with a beta well above 1, PZI can be an excellent short-term trade when equity markets are moving higher.

Bottom line: PZI isn’t an ETF for everyone, but it’s an excellent idea for the investor looking for micro-cap exposure that plans to take gains of 15%, 20% or more, if PZI delivers them in 30 to 90-day time horizons. As small-caps rally in January 2012, keep an eye on PZI.

Posted by Micro Trader