A small-cap index fund is a type of exchange-traded fund (ETF) that tracks an index of small-cap stocks. Small-cap index funds are invested in all the stocks of a small cap-focused index, such as the Russell 2000 (RUSSELLINDICES:^RUT), with the goal of matching the performance of the index itself.
Small-cap index funds give investors exposure to broad ranges of small-cap stocks, which are often the stocks of young companies with smaller profits than more established companies. For a small-cap company, the market capitalization, or market cap, which equals share price times the number of shares outstanding, generally falls between $300 million and $2 billion.
Investing in small-cap index funds confers many benefits:
- Portfolio diversification: Investing in a small-cap index fund exposes your portfolio to a wide range of small-cap stocks across different sectors. Diversified portfolios generally perform better than non-diversified holdings because owning the stocks of many different companies ensures that your portfolio's performance is not strongly correlated with the performance of any specific stock and is more resistant to bear markets.
- Risk reduction: Small-cap stocks can be risky since they tend to move cyclically with the broader economic cycle. They are also more volatile than large-cap stocks. Investing in an index fund eliminates some of the risk because the fund gives you a stake in dozens of companies.
- Bull market gains: While large-cap companies are more likely to be profitable, have better access to capital, and can better withstand recessions, small-cap companies tend to outperform during bull markets, which occur when the stock market is on the rise.
- Attractive growth potential: The stocks of small-cap companies have historically outperformed those of large-caps, thanks to their greater growth potential.
The chart below shows that the small-cap Russell 2000 has beaten the large-cap S&P 500 (SNPINDEX: ^GSPC) since 1979. The chart also shows that small-cap stocks are more volatile than those of large-cap companies.
However, it's important to note that, due to small-cap stocks' volatility, investors' small-cap holdings are likely to lose more value during market crashes. During the March 2020 crash caused by the COVID-19 pandemic, the values of small-cap stocks fell faster than the value of the broader market, as expected. But small-cap stock prices also rebounded more quickly, especially after Pfizer (NYSE:PFE) announced successful vaccine trials.
If you want to gain broad exposure to small-cap stocks, these four small-cap index fund ETFs are good options:
4 top small-cap index funds
|iShares Russell 2000 Growth ETF||(NYSEMKT:IWO)||0.24%|
|iShares Core S&P Small-Cap ETF||(NYSEMKT:IJR)||0.06%|
|Schwab U.S. Small-Cap ETF||(NYSEMKT:SCHA)||0.04%|
|Vanguard Small-Cap Value Index ETF||(NYSEMKT:VBR)||0.19%|
iShares Russell 2000 Growth ETF
As its name implies, the iShares Russell 2000 Growth ETF aims to track the Russell 2000 Index.
This index fund ETF has performed well in bull markets but also falls faster when stocks are down. For example, through June 16, 2022, the ETF was down 34% compared to a 23% loss for the Russell 2000. A growth-oriented fund such as the iShares Russell 2000 Growth ETF carries more inherent risk, but it has a reasonable expense ratio of 0.24% for investors looking for small-cap growth.
iShares Core S&P Small-Cap ETF
The iShares Core S&P Small-Cap ETF, with $71 billion in assets, is the biggest small-cap index fund on the market. The fund seeks to track the performance of the S&P Small Cap 600 Index by holding a broad array of stocks, including Macy's (NYSE:M), Shake Shack (NYSE:SHAK), and Saia (NASDAQ:SAIA).
Schwab U.S. Small-Cap ETF
The Schwab U.S. Small-Cap ETF tracks the small-cap holdings of the Dow Jones U.S. Total Stock Market Index. This is sort of a middle-of-the-road index fund ETF. It is neither overly conservative nor too aggressive with its holdings. Since it holds a mix of high-risk and low-risk stocks, the risk is lower than it would be for a purely growth-oriented fund. If you're a believer in diversification, this fund provides it.
A cheap expense ratio of 0.04%, along with a 10-year compound annual growth rate of 10.4% including dividends, makes the ETF an appealing way to invest in domestic small-caps. The fund's allocation includes 16% in financials, 16% in industrials, and 14% in technology. The fund also pays a dividend at a yield of 1.2% of the share price.
Vanguard Small-Cap Value Index Fund ETF
The Vanguard Small-Cap Value Index Fund ETF tracks the CRSP U.S. Small Cap Value Index. As a value-oriented index tracking fund, the ETF doesn't offer the highest share price growth potential, but it should outperform in bear markets. That's because valuations, especially of high-priced stocks, tend to compress in recessions.
Over the past 10 years, the CRSP U.S. Small Cap Value Index has increased annually with dividends factored in, underperforming the Russell 2000 as value stocks have fallen out of fashion. Still, that almost certainly will change at some point. In fact, the ETF has outperformed both the S&P 500 and the Russell 2000 for the year to date. Currently, the fund offers a dividend of 1.8% and an attractive expense ratio of 0.19%.
Is a small-cap index fund right for you?
As you can see from the list above, small-cap investing doesn't have to be complicated. The four index fund ETFs offer a range of benefits, including growth, value, and income, and all have solid track records. With thousands of small-cap stocks available on the market, buying one of these is a smart and convenient way to reduce the risk of investing in the sector by gaining exposure to a wide range of companies with just one or two investments.
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