Find Small-Cap Winners the Simple Way

If you're looking for an area where individual investors have the best potential to earn amazing long-term returns, you need to look closely at small-cap stocks. And if you want to earn those returns without doing a lot of research on your own, then funds that focus on small caps could make your life a lot simpler.

Over the past year or so, the stock market has been tremendously volatile, alternating between stomach-churning plunges and amazing rallies. Nowhere has that volatility been more evident than among small-cap stocks, and the big dips have uncovered some amazing opportunities for investors looking at small-caps.

So it's no wonder that people are paying more attention to stocks of small companies. But with all the small-cap stocks out there, what's the best way to find those that have the most potential to earn some of those top returns for yourself? Let's take a look at some of the choices that investors can use to build a strong portfolio of small-cap investments quickly and easily.

A look at small-cap ETFs
Exchange-traded funds have become extremely popular in recent years, as many investors are attracted to their ease of use and their transparency. Unlike with most traditional mutual funds, ETF investors find out every day which stocks their funds own, and their structure makes it easier for investors to manage things like record-keeping and the tax ramifications of trading.

You can find several small-cap ETFs with substantial amounts of money under management. Although they each appeal to small-cap investors, the four ETFs below use different strategies to select the stocks they own. Here's a quick summary:

  • The iShares Russell 2000 Index ETF (IWM) has more than $11 billion in assets and tracks the well-known Russell 2000 index of small-cap stocks. Although it clearly has a small-cap focus, it also includes a few stocks that push the $2 billion market-cap level, including Palm (Nasdaq: PALM  ) and Tupperware Brands (NYSE: TUP  ) . However, it includes a significant number of microcap stocks as well.
  • The iShares S&P SmallCap 600 Index ETF (IJR), with roughly $4.4 billion under management, tracks Standard and Poor's small-cap index. The average market capitalization of its stocks is somewhat higher than the Russell-tracking fund, with stocks like Green Mountain Coffee Roasters (Nasdaq: GMCR  ) and Atwood Oceanics (NYSE: ATW  ) pulling up the average somewhat.
  • The Vanguard Small-Cap ETF (VB) lags the iShares funds with just $1.9 billion in assets. It tracks yet another index, the MSCI Small Cap 1750 Index, and counts Dendreon (Nasdaq: DNDN  ) and Genworth Financial (NYSE: GNW  ) among the relatively numerous mid-cap stocks its owns.
  • For those who prefer to look at truly tiny stocks, the iShares Russell Microcap Index ETF (IWC) fits the bill. With just over $300 million in assets, it may not be the most popular fund. But its average market cap of less than $200 million puts the ETF squarely in microcap territory, owning relatively unknown stocks like Neogen (Nasdaq: NEOG  ) .

Here's a look at how each of these ETFs has performed:

Small-Cap ETF

YTD Return

1-Year Return

3-Year Avg. Annual Return

5-Year Avg. Annual Return

iShares Russell 2000

15.0%

(21.6%)

(6.2%)

2.3%

iShares S&P SmallCap 600

12.3%

(21.3%)

(6.0%)

2.6%

Vanguard

20.2%

(19.1%)

(5.0%)

3.2%

iShares Russell Microcap

15.7%

(21.9%)

(10.3%)

N/A

Source: Morningstar.

Which to pick
Looking at all four funds, the performance differences don't appear hugely significant. Vanguard has a slight long-term edge, perhaps due to its lower costs, while the microcap-focused fund has trailed its small-cap competitors over the past three years. The Vanguard ETF's tendency toward holding more mid-cap stocks may have worked in its favor -- because Russell graduates stocks to its larger-cap index faster than MSCI does, the MSCI Small Cap Index can hold onto a quick-growing stock longer. Yet over the long haul, I could easily see such considerations cycling in and out of favor.

As I see it, any of these ETFs gives you good exposure to the small-cap universe. While Vanguard may have a small edge based on performance and expenses, the larger iShares fund may enjoy some liquidity advantages that make them more suitable for more frequent traders.

Stick with small caps
If you want the opportunity for amazing growth, you definitely need to own some small-cap stocks. Picking a good small-cap ETF makes it easy to broaden your portfolio and improve its long-term returns.

Fools generally like small-cap stocks, but Todd Wenning knows one you should avoid. Steer clear of small-cap traps with the help of our Motley Fool Hidden Gems newsletter, where you'll get new stock recommendations and analysis every month. Click here to start a free trial today.

Fool contributor Dan Caplinger makes sure to include small-caps in his portfolio. He doesn't own shares of the companies mentioned in this article. Green Mountain Coffee Roasters is a Motley Fool Rule Breakers selection. Atwood Oceanics is a Stock Advisor pick. Tupperware Brands is an Income Investor pick. The Motley Fool wrote puts on Tupperware. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy isn't sensitive about its size.


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