A small-cap index fund is a type of exchange-traded fund, or 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 Index (RUSSELLINDICES:^RUT), in order to match 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 fairly low stock prices. 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 large number of small-cap stocks, which diversifies your holdings. 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.
  • Risk reduction: While small-cap stocks can be risky, as they tend to move cyclically with the broader economic cycle and are more volatile than large-cap stocks, investing in an index fund eliminates some of the risk since 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 potentials.

The chart below shows that the small-cap Russell 2000 has beaten the large-cap S&P 500 (SNPINDEX:^GSPC) over its 40-year history. The chart also shows that small-cap stocks are more volatile than those of large-cap companies.

^RUT Chart

^RUT data by YCharts.

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 coronavirus pandemic, the values of small-cap stocks predictably fell faster than the value of the broader market. But the small-cap stocks' prices also rebounded more quickly, especially after Pfizer (NYSE:PFE) announced successful vaccine trials.

If you want your portfolio to gain broad exposure to small-cap stocks, these four small-cap index fund ETFs are good options:

Four good small-cap index funds

Fund Ticker Expense Ratio
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)  0.07%

Source: Yahoo! Finance.

1. iShares Russell 2000 Growth ETF: As its name implies, the iShares Russell 2000 Growth ETF aims to track the Russell 2000 Index. It's an ideal play for 2021 if you believe the current stock market recovery will continue.

This index fund ETF has an impressive track record, with a compound annual growth rate (CAGR) of roughly 13.9% over the past 10 years. That beats the S&P 500, as well as many other small-cap investments. A growth-oriented fund like the iShares Russell 2000 Growth ETF carries more inherent risk, but it also has a low expense ratio of 0.24%.

Hand lining up dice reading "ETF" and an up arrow

Image source: Getty Images.

2. iShares Core S&P Small-Cap ETF: The iShares Core S&P Small-Cap ETF, with $56 billion in assets, is the biggest small-cap index fund on the market. The fund aims to track the performance of the S&P Small Cap 600 Index by holding a broad array of stocks, including Capri Holdings (NYSE:CPRI)Yeti Holdings (NYSE:YETI), and Saia (NASDAQ:SAIA).

Over the past decade, this index has slightly outperformed the S&P 500, posting an annual return rate of 11.6%. It has an expense ratio of 0.06% and offers a dividend yield of 1.1%.

3. 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, and 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 CAGR of 11%, make this ETF an appealing way to invest in domestic small-caps. The fund's allocation includes 14% in financials, 18% in healthcare, and 15% in industrials. The fund also pays a dividend at a yield of 1.1% of the share price. 

4. 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, this ETF doesn't offer the highest share price growth potential, but it should outperform in bear markets. That's because valuations, especially overvaluations, tend to compress in recessions.

Over the past 10 years, the CRSP U.S. Small Cap Value Index has annually increased by 8.5% on average, underperforming the S&P 500 as value stocks have fallen out of fashion. Still, that could change, and it almost certainly will at some point. Currently, the fund offers a dividend of 1.7% and an attractive expense ratio of 0.07%. 

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. These 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 a couple of investments.