Exchange-traded funds are hot. The passive investment vehicles had new inflows of more than $38 billion through September, and more and more ETF products are appearing on the markets every day.

In fact, the number of ETFs trading today is almost overwhelming. You can buy sectors, strategies, indexes, and countries in nearly any combination.

Yet the benefits of ETFs are enormous. The low-cost vehicles are easy to trade and have no investment minimums. And because they've gotten so specialized, they can help you both diversify and fine-tune your portfolio to minimize volatility and maximize returns.

So which ETF do you need to buy to perfect your portfolio?

Go small, or go home
The iShares Russell Microcap Index Fund (NYSE:IWC) is a pick every investor should consider. Why? Because it tracks the most rewarding part of the stock market: extremely small companies.

That's why Russell Microcap is such a powerful asset allocation tool for individual investors: The average market cap of the ETF's holdings is just $340 million, and none of the top 10 holdings is larger than $900 million -- and that one is a stock that's nearly doubled over the past year.


Market Cap (millions)

City Bank






World Acceptance


Integra Bank


One Liberty Properties


Independent Bank


Gladstone Commercial






Cast a wide net
While stocks this small can be dangerous for individual investors to dabble in without proper diversification, the 10 best stocks of the past 10 years at one time probably would have been or would have become holdings in this ETF. At a $515 million market cap, perhaps Yahoo! (NASDAQ:YHOO) would have even been among its top holdings 10 years ago. Indeed, I'll go out on a limb (not really) and say that many of tomorrow's big winners are already a part of Russell Microcap.

And while you think you may have exposure to small companies via a broad index such as Vanguard Total Stock Market, that's just not the case. Micro caps make up just 2% of Total Stock Market's holdings. That's right. Two percent! Because that fund is market-cap weighted, the bulk of your "Total Stock Market" holdings is stashed in megacaps such as ExxonMobil (NYSE:XOM) and General Electric (NYSE:GE).

The Foolish bottom line
Most investors could benefit from making micro caps a larger part of their portfolio. And while doing so within the context of an ETF that holds nearly 1,500 names will mute returns, it will also mean that you're not subjected to the wild price swings that characterize these small stocks.

If you agree with that position, let us know in our brand new Motley Fool CAPS community intelligence database by rating IWC "outperform." And if you disagree, go ahead and rate it "underperform." Our goal is to harness the power of individual investors to help determine the best ETF for 2007. You can help by joining CAPS and offering your thoughts. Just click here to get started.

Go here for the complete list of ETF contenders in our CAPS tournament. And for more information on exchange-traded funds, visit the Fool's ETF Center.

Tim Hanson does not own shares of any company mentioned. Yahoo! is a Motley Fool Stock Advisor recommendation. Because just like every night has its dawn and every cowboy sings his sad, sad song, The Motley Fool has a disclosure policy.