Small-cap stocks have been solid performers over the last couple of years, and investors are fortunate that they can find many exchange-traded funds to choose from in this area. Close to 20 ETFs, in fact, have "small cap" in their moniker.
However, not all small-cap ETFs are alike. The funds' returns, the fees they charge, and the indices that the funds follow can vary significantly. And although the majority of small-cap ETFs track U.S. stocks, some now follow global indexes, and others provide investors the ability to short or magnify their exposure to this segment of the market.
Although the definition of small-cap stocks is loosely interpreted, it is usually associated with stocks having a market capitalization of less than $2 billion or so. Generally, the small-cap benchmarks stick to this range but do not slavishly follow these criteria, so you will see some exceptions. Popular indices for the small-cap ETFs and the fund groups that track these benchmarks are the Russell 2000/S&P SmallCap 600 Indexes (Barclays/ProShares), MSCI Small Cap 1750 Index (Vanguard), and the Dow Jones Wilshire Small Cap Index (SPDRs).
Small-cap summary
Barclays and State Street have had small-cap ETF funds since 2000, longer than any of the other players, with Vanguard having joined the game in 2004. Rydex, WisdomTree, and ProShares have just recently come to market and provided even more choices for investors. The increased competition means that investors can now choose from among broadly diversified small-cap funds, value and growth funds, and some funds that track very specialized small-cap indices.
Barclays has the largest number of ETF offerings and is also the current favorite among investors who have placed close to $26 billion in a half-dozen small-cap funds from this ETF sponsor. The closest competitor by dollar value, Vanguard, is far behind the sector leader, with just about $2 billion in three funds.
Performance writ large
Paradoxically, two of the best-performing small-cap ETFs are funds with the largest amount of assets -- both from Barclays. The biggest one, iShares Russell 2000 (NYSE:IWM), currently has nearly $10 billion in assets, and its low expense ratio of 0.2% is an additional positive feature. The second-largest fund, iShares Russell 2000 Value (NYSE:IWN), has $4.5 billion in assets and can claim a slightly better performance record than IWM but also charges a higher expense ratio of 0.25%. In 2006, the 23% return of IWN compared with the 18% return of IWM more than covered the difference in costs, but keep in mind that since the tech crash of early 2000, both value stocks and small caps have been on a tear. When this outperformance finally comes to an end, you may face a double hit with IWN.
Small-cap benchmarks
Since Barclays' funds currently have the most assets, it makes sense to take a closer look at the indices that these funds track.
The S&P SmallCap 600 Index consists of, as you might guess, 600 small-cap stocks. It adds stocks to the index based not only on size but also on financial viability, liquidity, adequate float size, and other trading requirements. It's market value-weighted, meaning that larger companies have a greater influence on its performance than do smaller ones. However, it's also a relatively evenly distributed index -- the top 10 holdings represent only 5% of its value. Companies with market capitalizations between $300 million and $1.5 billion are what this index focuses on. Current holdings range in size from $60 million to more than $3 billion, with the average company boasting a market cap of around $750 million.
The Russell 2000 includes the smallest 2,000 securities in the Russell 3000 and has an average market cap of $1.2 billion. Since it contains only small firms, the index represents a mere 3% of the value of the overall market.
If you are looking for the most diversification, then you should select a fund that tracks the Russell. Another consideration is that Russell's approach to selecting stocks is quantitative, while Standard & Poor's is more qualitative. Russell looks only at market cap to determine which companies go into the index. S&P, meanwhile, takes a more qualitative approach and runs its indices by committee, which means there is subjectivity in which companies are included or excluded.
New kids on the block
In late January 2007, ProShares launched the first ETFs in the U.S. to provide magnified or short exposure to small-cap indexes. The series of six funds are benchmarked to the S&P SmallCap 600 Index and the Russell 2000, with three funds for each index. The "Ultra" funds of this group seek to double the daily return of the index, regardless of whether it rises or falls. For example, the Ultra SmallCap600 ProShares fund (AMEX:SAA) seeks daily investment results, before fees and expenses, that correspond to 200% of the daily performance of the S&P SmallCap 600 Index. This arrangement can double your pleasure on the way up, but it can also double your pain when markets crash.
The "Short" strategy, meanwhile, gives the inverse daily return of the index -- when the market rises 2%, the fund loses 2%. If that isn't enough volatility for you, there's also the "Ultra Short" fund, which seeks returns of double the opposite of the market return.
Midway through 2006, WisdomTree launched its International SmallCap Dividend Fund (NYSE:DLS), which focuses on the small-cap, dividend-paying companies in the industrialized world outside the U.S. and Canada. Since the fund's inception in mid-June of 2006, DLS has racked up a 25% return, more than paying for its 0.58% expense ratio. With global markets on a tear in 2006 and the dollar weakening, this fund has already gathered more than $180 million in assets.
So many selections
Investors seeking a small-cap ETF now face a menu of offerings. With so many options available, you can now select a fund based on fund sponsor, style, fees, performance and the index that is tracked. Although picking a small-cap fund may seem to be a daunting task with so many flavors to choose from, most investors should just stick with a broadly diversified fund that has a good track record and low fees. The good news is that there are several of these funds to choose from.
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Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds or stocks mentioned in this article. The Motley Fool has a disclosure policy.
