One of our main messages at The Motley Fool is that for many people index funds are the first and only stop they need to make on the investing train. Yes, for those who don't have the time or inclination, it's perfectly fine to cut things short and stop at Step 4 of the 13 Steps to Investing Foolishly. Why? Because it's an easy, low-cost way for individuals to participate in the market, while still outperforming the majority of actively managed mutual funds. Despite the last couple of years (ouch!!!), we still think the market is the best way to slowly build wealth, and broad-market indexing is the easiest, best way for many folks to participate.
When many people think of indexing, they think of the S&P 500. (The largest index fund in the world is the Vanguard 500 Index Fund, with over $73 billion in net assets.) Because it is representative of the market and easily matched via index funds, we tend to use the S&P 500 as a benchmark against which our returns are measured. It's easy to see why: If we can't exceed the S&P 500, we might as well quit wasting our time (and money) and just invest in it. In other words, if you can't beat 'em, join 'em.
But what about us small-cap investors? Should we view indexing in the same light? What, exactly, should we be measuring our returns against, and is there an index we can turn to if we decide we're not adept at picking small-cap winners? These are great questions, and I'm not just saying that because I'm writing an article on them.
Let's start by taking a look at the some of the small-cap indexes out there. Here are three of the most popular:
Russell 2000 Index - Measures the performance of the 2,000 smallest companies in the broad-market Russell 3000 Index. Represents approximately 8% of the total market capitalization of the Russell 3000.
Wilshire Small Cap 1750 Index - A subset of the broader-market Wilshire 5000; comprised of the next 1,750 largest stocks -- from 751 to 2,500 by market cap.
S&P SmallCap 600 - Consists of 600 domestic stocks chosen for market size, liquidity, and industry group representation. Market capitalization generally ranges from $300 million to $1 billion.
Here's how these three have fared against the S&P 500 over the years:
Annualized Returns Index 1 yr 3 yr 5 yr 10 yr Russell 2000 -3.6 5.6 6.9 10.5 Wilshire Small Cap -6.1 7.0 8.5 11.8 S&P SmallCap 600 7.9 13.9 10.6 N/A S&P 500 -9.5 -2.5 8.5 12.6 Sources: Morningstar, Barra
Are any of these small-cap indexes worthy benchmarks? Certainly, it can't hurt to measure our small-cap returns against any and all of these. Anything that gives us another data point to measure our investing progress is always helpful.
I think the S&P 500 should still be the final benchmark against which to measure your entire portfolio's returns, however. For most people reading this column, small-cap stocks will only make up a portion of their total ports. But even if your entire port is made up of small caps (not something we'd recommend), the S&P should still be your final benchmark (for the reasons outlined above).
What about investing in a small-cap index? There's no single right answer to this question. Everyone has unique circumstances and many factors are involved in making such a decision, such as age and risk tolerance. However, I think the general answer to the question is "no."
Those considering such an index should ask themselves why they are interested in small caps in the first place. Many who faithfully read this column love to ferret out promising small-cap stocks, perform thorough research, discuss companies with others on our Foolish Eight discussion board, and, ultimately, invest in some of those diamonds-in-the-rough. In short, they like this stuff, and they know that being a successful small-cap investor can juice a portfolio's returns over the long term. For these folks, it's doubtful that one of the small company indexes is for them. They're trying to beat the them, not match them.
So, for the research-loving, number-crunching, small-cap "stock jock," indexing is not a great fit. For those who'd like to participate in small-cap investing, but don't have the time or ability to do so, it's also not a great fit for one simple reason: This is one area in which good, professionally managed funds tend to outperform the indexes.
Sure, small-cap fund managers face the same obstacles their broader-market brethren face, namely higher expenses in the form of salaries, fancy buildings, brokerage fees, etc. That's why broad market indexes outperform managed funds over the long run (by about 1.8% per year, on average, which translates into many thousands, or even millions, of dollars).
A small-cap index, however, must disadvantage itself in a way a small-cap fund doesn't have to. Once a stock appreciates enough to move out of small-cap territory, it is sold by the index and replaced with another, smaller company. (If a small-cap index didn't do this, it wouldn't remain a small-cap index.) So, once future giants begin to stretch their legs, they're cut out of the indexes before they really begin to dominate their markets and strengthen their moats and become household names. The small indexes, in other words, violate the Foolish maxim of "letting the winners run."
A small-cap fund manager, however, doesn't have to worry about this. She can hold on to a future Wal-Mart (NYSE: WMT) while it continues to execute well and doubles and triples in price. If you need further convincing, consider that over the past five years only 27% of large-cap managed funds outperformed the S&P 500, while 70% of small-cap managed funds topped the Russell 2000, according to Mutual Fund magazine.
Of course, if you decide to invest in an actively managed small-cap fund, you'll have to do some homework to see which funds have done well in the past and are likely to continue to do well in the future. A good place to start is Morningstar.com, where you can screen funds until you find some that fit your criteria. Then, dig a little deeper by reading some prospectuses and everything you can find on the fund companies' websites.
If you've had any experiences with small-cap indexes or actively managed funds -- good or bad -- please share them on our Foolish Eight discussion board.
Due to time constraints, Rex Moore regrets to announce he is no longer available for birthday parties. The Motley Fool's disclosure policy should be enjoyed by the whole family.
