Why Buy a Penny Stock Index Fund?

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I’ve had a few questions come up lately regarding penny stock indexes versus individual stocks and why a trader would choose one over the other. Good question, but first for our beginners’ benefit, let’s define what a penny stocks index actually is. A penny stock index, like other indexes, is an investment vehicle comprised of stocks in the correct proportions that make up a particular section of a stock market, in this case micro-caps.

How to Buy Penny Stock Index Funds

You can’t actually go out and buy the penny stock index, unless you’re willing to buy each and every stock comprising it, a ludicrous idea in itself. Instead however you can buy what are called index funds which are investment vehicles that closely track a specific index. Though there are some actively managed penny stock funds out there I prefer a penny stock ETF (Exchange Traded Fund). The main difference between an actively managed mutual fund and an ETF is that with an ETF, the fund company is merely trying to replicate the index which translates to much lower management fees and less risk since you’re not relying on a particular money manager’s expertise. Of course some may argue that if the manager is particularly good at selecting penny stocks you can do far better with managed funds but again, be aware then that you’re hedging your bets on a single money manager versus the overall index. To each his own.

Now as mentioned in my other articles, a penny stock can be defined in a number of ways so you shouldn’t be surprised that fund company’s definitions of micro cap stocks vary as well. Some define them as any stock below a certain market cap (e.g. $300 million) while others simply take a set number of stocks from the index such as the bottom 1000 stocks by market cap and call them micro-caps. Regardless of how they’re defined however there a number of excellent low fee micro-cap funds worth considering.

Best Penny Stock Index Fund

One of the most popular, and best penny stock index funds as far as I’m concerned, is the iShares Russell Microcap Index Fund (NYSE: IWC). This index fund is based on the bottom 3% of the US stock market and the main reason I like this fund is its high liquidity and volatility, allowing you to easily day trade it, swing trade it, or even invest in it for the long term. Some of the other microcap funds worth mentioning include the Vanguard Small-Cap ETF (AMEX: VB), the PowerShares Zacks Micro-Cap ETF (NYSE: PZI), and the iShares Morningstar Small Core ETF (NYSE: JKJ).

The great thing about these penny stock ETFs is that like all other ETFs, they trade like regular stocks and can be bought and sold easily within your discount brokerage account. As such, they can also be shorted as a hedge or even bought on margin (though I wouldn’t suggest this unless you truly are a trading professional).

Benefits of Index Funds

So why buy a penny stock fund rather than a group of handpicked penny stocks? Well, it really depends on what you are trying to achieve in your investment portfolio. If you’re looking for aggressive growth but just can’t stomach the risks of individual penny stocks, a penny stock index fund might just be the investment vehicle you need. Though they will certainly not achieve the same level of gains a high potential penny stock pick can yield, they do provide higher growth potential than your average index fund or even blue chip stocks. Another big advantage is that you no longer have to worry about the large amount of risk associated with individual small cap companies since in essence you are well diversified, investing in hundreds of stocks through one investment unit.

Drawbacks of Index funds

The main downside of a penny stock fund however is that, well it’s a fund and no matter how well the fund performs, it can never achieve the same results a few good penny stocks can yield. In other words you’ll never see a fund gain 50% in one day, let alone 1000%, which can definitely happen with the right penny stock.

So in a nutshell, though a penny stock index can make an excellent addition to your portfolio and be used for certain investment strategies, if you’re in the market to make significant returns in a relatively short period of time, there really is no substitute for trading penny stocks. If you do go down the path of individual stocks however, you have to recognize the extra risk you’re taking on and thus should do everything in your power to help mitigate that risk. Use stop losses, limit penny stocks to a small percentage of your stock portfolio, never invest more than 5% of your equity in any one stock, consult a reputable financial advisor, and above all never use money you can’t afford to lose.

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