Most people would rightly consider an S&P 500 index fund to be a "starter fund" for passive investing. While large-cap index trackers certainly have the potential to make you a millionaire one day, there are other exchange-traded funds (ETFs) that can provide additional benefit to your overall portfolio.
Let's look at a popular but lesser-known fund, the Vanguard Small Cap Index ETF ( VB 2.20% ). From upside growth potential to added diversification and low costs, VB stands as a sensible long-term option for investors seeking to take their portfolios into the seven digits.
Potential for outsized returns
The Vanguard Small-Cap Index ETF invests in companies with market capitalizations of $300 million to $2 billion, broadly speaking. Needless to say, you won't find Amazon ( AMZN 1.88% ) or Apple ( AAPL 2.27% ) in this fund. Instead, you'll see companies that you've likely never heard of -- and that's for good reason: These companies currently operate on a relatively small scale but have the potential to reach great heights in the future. Investing in small-cap companies while they're still small can lead to unusually large returns if they eventually graduate to mid- or large-cap status.
It's extremely cheap
A core tenet of good financial planning is that expenses need to be top of mind for any long-term investor. We've previously explored the hard reality that even a 1% fee layered on your investments has the potential to decimate your after-tax returns over time.
The Vanguard ETF boasts an expense ratio of 0.07%, exceptionally cheap relative to comparable small-cap funds, which can cost, on average, up to 1.10%. It stands to reason that your investments are more likely to grow to million-dollar levels if you are, metaphorically speaking, swimming with the current rather than against it.
Provides further diversification
By adding an ETF that invests in many small-cap companies to an existing account that already contains large- and mid-cap companies, you're positioning yourself for a maximal diversification benefit. This means that, in totality, you're holding a vast swath of companies both large and small, which maximizes your opportunity for total return and minimizes the probability of catastrophic portfolio failure.
Additionally, the benefits of holding many small-cap companies, as opposed to just one or two, are well documented. These companies are typically toward the earlier stages of their existence, may have significant debt, or may not yet be profitable. It's best to avoid trying to pick the future winners and losers of the small-cap universe and choose a fund that picks out a large swath of the space. Vanguard Small-Cap Index ETF sets itself apart in the ETF universe by doing just that.
Potential for price inefficiencies
Because there's less information available about small-cap companies (fewer research analysts cover these stocks and a smaller share of the investing public is generally aware of them), small-cap stocks have a greater potential for pricing inefficiency. This means that Vanguard's portfolio managers are more likely, albeit marginally, to find companies with stock prices that don't accurately reflect fundamental value.
There's also a great level of variability in quality across the small-cap universe, so while some stocks have tremendous growth potential, some will literally go bankrupt. With Vanguard's small cap ETF, there's a big opportunity to take advantage of price inefficiencies in companies that have yet to become household names.
A valuable add-on
It's not necessary or recommended to hold the Vanguard Small-Cap Index ETF as a stand-alone fund or hold more than 20% in your overall portfolio. To achieve optimal results from a risk/reward perspective, it's best to use the fund as a supplement to a large-cap fund, like an S&P 500 index fund, and a mid-cap fund, like an S&P MidCap 400 index fund.
The Vanguard fund has a number of competing "sister funds" that may also fit your needs in a similar manner, depending on the brokerage you're using. In sum, when evaluating your portfolio from a birds-eye view, it's imperative to include some small-cap exposure, and Vanguard Small-Cap Index ETF fits the bill.