The Best Small-Cap ETFs

Exchange-traded funds can be an investor's best friend. They offer an inexpensive way to get exposure to the market, but provide much greater trading flexibility than traditional mutual funds. But as ETFs' popularity has soared, so has the number of funds available.

With hundreds of ETFs now filling the market, a potential investor must search diligently to find the specific fund that's right for him or her. Below, we'll examine some of the best small-cap ETFs around; if you're in the market for some small-cap exposure, listen up.

Small-blend ETFs
If you want to stick as close to the traditional small-cap benchmark as possible, an index tracker such as the iShares Russell 2000 Index ETF (NYSE: IWM  ) is right up your alley. This fund uses a sampling strategy to track the Russell 2000 index, which consists of 2,000 of the smallest capitalization-weighted companies included within Russell's broader 3000 index. This fund has been around longer than many ETFs, and it's done a pretty good job of tracking its index. The fund will tend to lag the Russell 2000 each year by roughly the amount of its expense ratio (0.20%), but that's not unexpected.

If you're looking to track a slightly different small-cap benchmark, try the Vanguard Small-Cap ETF (VB). This fund tracks the MSCI US Small Cap 1750 index, which represents about 11% of the total U.S. equity market and counts Kansas City Southern (NYSE: KSU  ) and DeVry (NYSE: DV  ) among its top holdings. This particular index can perform quite differently from the Russell 2000 at times, and it tends to be a bit more volatile. Therefore, expect this fund to experience more swings in returns from year to year. But the fund's low 0.10% expense ratio is hard to beat.

On the other hand, if you're willing to take a slight bet on some active management, the iShares Morningstar Small Core ETF (JKJ) may work for you. This fund tracks the performance of the Morningstar Small Core Index, which Morningstar built to measure the performance of some of the smallest companies in its U.S. Market index.

Morningstar also adds some quantitative screens to the index, to include only those small-cap stocks with low prices in relation to their earnings, book value, cash flow, and dividends. You'll find shares of companies such as Big Lots (NYSE: BIG  ) and Valeant Pharmaceuticals (NYSE: VRX  ) among its holdings. This fund has performed relatively well compared to its peers over its short four-year life span, and it comes with a reasonable 0.25% expense ratio.

Small-value ETFs
While it's usually not necessary to buy style-specific funds at the small-cap level, there are several options available if you need such an investment. One of the better small-value funds is the iShares S&P 600 Value ETF (IJS). This fund tracks the performance of the S&P Small Cap 600/Citigroup Value index, which consists of those holdings from the S&P 600 Index with the lowest price-to-book ratios. This fund has been around for eight years now, charging expenses of 0.25%. The S&P 600 index is also a bit more volatile than some of the broader small-cap indexes, although all small-cap funds have suffered along with the rest of the market in 2008.

Small-growth ETFs
On the growth side, the Vanguard Small-Cap Growth ETF (VBK) is a great option. This ETF tracks the MSCI US Small Cap Growth Index, which consists of the more growth-oriented companies of the MSCI US Small Cap 1750 Index. Since its January 2004 inception, the fund has used a full replication method of tracking, seeking to invest in all of the stocks that make up the index. Those holdings include FTI Consulting (NYSE: FCN  ) and Myriad Genetics (Nasdaq: MYGN  ) , among others. An impressive 0.11% expense ratio makes this fund a great choice for growth-minded small-cap investors.

A parting reminder
Whichever route you take to get your small-cap exposure, don't try to time the market by getting into a bear-market fund in anticipation of a market drop. Investors are notoriously bad at timing calls like this. Despite their recent success, bear-market funds go down more often than they go up, so Fools are best served by staying away from ETFs that short the small-cap market. Stick to broad, well-diversified funds, and your ETF experience will likely be a positive one.

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This article was originally published on Aug. 29, 2007. It has been updated by Dan Caplinger, who doesn't own shares of the companies mentioned. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.


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