From 1927 to 2004, small-cap value outpaced large-cap growth, large-cap value, and small-cap growth -- by a significant margin.

Returns alone make a compelling case for including small-cap value stocks in your portfolio. Of course, with small caps, vetting potential investments requires an added layer of scrutiny.

They took the bar. They took the whole . bar!
Shrewd investors who want blanket diversification or added exposure would do well to examine the Vanguard Small-Cap Value (AMEX:VBR) exchange-traded fund.

I know, I know, ETFs seem to be everywhere right now. But while there are more mutual funds than individual stocks on the U.S. markets, at the close of September, there were only 290 ETFs -- though that figure may double (and then some) in 2007. More choice is good for investors -- but it can be incredibly overwhelming.

The case for the Vanguard Small-Cap Value ETF, however, isn't overwhelming or complicated. The ETF:

  1. Is cheap. The expense ratio is a paltry 0.12%. (A larger competitor dings you 0.25%.)
  2. Offers broad but smart diversification. The ETF holds 985 names, all told, so volatility is muted.
  3. Puts the power of the market's best asset class in your portfolio. While small caps in general outperform over the long haul, small-cap value in particular is a catalyst.

The skinny
Vanguard Small-Cap Value tracks the MSCI U.S. Small-Cap Value Index. The fund's average market cap is $1.4 billion, although the top 10 holdings look a bit larger:

Company

Market Cap

TTM P/E

Camden Property Trust (NYSE:CPT)

$4.2 billion

20.2

Federal Realty Investment Trust

$4.4 billion

35.6

Ventas (NYSE:VTR)

$3.9 billion

27.8

Northeast Utilities

$4.0 billion

36.0

Reckson Associates

$3.6 billion

27.5

Plains Exploration & Production

$3.3 billion

N/A

OGE Energy

$3.6 billion

12.3

Harsco (NYSE:HSC)

$3.4 billion

17.5

Mack-Cali Realty

$3.0 billion

34.0

Integrated Device Technology (NASDAQ:IDTI)

$3.4 billion

N/A
Top holdings as of Sept. 30, 2006.

These stocks tend toward the "mid-cap" spectrum, but keep in mind that while these are the largest holdings, they make up just 3.8% of net assets.

Fish in the right ponds
Going by total assets, the majority of Americans are invested in S&P 500-tracking funds or ETFs. Consider: Using the classic $200-million-to-$2-billion definition of small caps, there are 10 small caps in the S&P 500, and those 10 make up 0.15% of assets. By comparison, IBM (NYSE:IBM) and Wells Fargo (NYSE:WFC) make up 2% combined.

Which is to say: The majority of U.S. investors have little exposure to this segment. And the Vanguard Small-Cap Index gives investors instant diversification.

Foolish final thoughts
Small-cap value has outperformed in the past (for more than 70 years), and it's continued an impressive run-up recently.

Most investors could stand to gain something from putting this asset class to work in their portfolio. An ETF will lessen the returns of some of the biggest gainers, but it also lessens the volatility inherent in small-cap investing.

Agree with me? Let us know in our brand-new Motley Fool CAPS community investing database by rating VBR "outperform." If you disagree, 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 herefor the complete list of ETF contenders in our CAPS tournament. And for more information on exchange-traded funds, visit the Fool's ETF Center.

Brian Richards does not own shares of any company or fund mentioned in this article. The Motley Fool has a disclosure policy.