You might find this a bit cheeky, but the hottest stocks on the market aren't stocks at all -- they're exchange-traded funds (ETFs). Small-cap ETFs.

According to a recent article in The Wall Street Journal, small-cap ETFs are quickly becoming the latest, greatest way for hedge funds and pension funds to gain exposure to small companies -- the sector of the market that offers the best returns. Indeed, small caps have outperformed larger companies several years in a row now, and this year, the Russell 2000 remains about a percentage point ahead of the S&P 500.

That's performance that a lot of new money is chasing.

Where the big money flows
The iShares Russell 2000 Index, which counts smallish companies such as $2.1 billion FormFactor (NASDAQ:FORM), $1.8 billion BE Aerospace (NASDAQ:BEAV), $1.9 billion Aztar (NYSE:AZR), and $2 billion OSI Pharmaceuticals (NASDAQ:OSIP) among its top holdings, has seen its assets increase from $7 billion to more than $10 billion since the end of 2005.

Even more incredibly, the Vanguard Small Cap VIPERs -- which tracks the MSCI U.S. Small Cap 1750 Index and invests in the likes of $1.4 billion Rambus (NASDAQ:RMBS), $2.9 billion Aqua America (NYSE:WTR), and $3.5 billion Corporate Executive Board (NASDAQ:EXBD) -- has seen its assets double over the past 12 months.

Now, you'll notice an oddity here: The top holdings of these ETFs tend to be at the larger end of the small-cap spectrum -- they're all capitalized at $1.4 billion or more, with Corporate Executive Board at more than $3 billion. The more practical definition of a small cap is a company capitalized at less than $2 billion, and that's the soft cap we use to make recommendations at our Motley Fool Hidden Gems small-cap newsletter. Moreover, the best historical returns seem to come from smaller and smaller companies.

Stocks vs. sectors
The other oddity is that very smart hedge and pension fund managers are handing their money over to passive indices. They're not making bets on specific companies at all, but rather on the entire small-cap sector. That's an interesting move, since broad indices tend to be more efficiently priced than individual companies -- there are thousands of data points to evaluate rather than just a few -- and their returns will always be muted because the laggards will weigh down the best performers. The mind-blowing returns will come only when one invests in the very best companies at the very best prices.

So, why aren't hedge and pension funds making bets on individual stocks? Well, frankly, because they have too much money.

The downside of riches
You're probably thinking that's a pretty good problem to have, but it really isn't. Remember, Warren Buffett has said that he could earn 50% annual returns if and only if he had less than $1 million to invest. That's because he could then move nimbly in and out of small stocks -- the stocks with the best returns -- without moving the price or attracting a lot of attention. See, the problem with small companies is that their shares don't trade very much, and they're not very liquid. That's a problem for professional investors but an incredible opportunity for individual investors like you and me. For us, small caps are the very best place to make money.

The Foolish bottom line
So, what are the takeaways here?

  1. Small caps are a very profitable sector.
  2. Professional money managers are flocking to the sector to make money.
  3. Unlike professional money managers, you have the ability to put your money behind the very best small companies and (you hope) earn the best returns.

If you'd like to start investing in small caps and want a little help doing so, come and join us at Motley Fool Hidden Gems. Our team -- led by Fool co-founder Tom Gardner and analyst Bill Mann -- specializes in finding and recommending the best small public companies. We're having some success at it: Our recommendations have returned 26% on average over the past two-plus years, versus just 12% for the large-cap-laden S&P 500 index. Click here to get started.

This article was originally published on April 21, 2006. It has been updated.

Tim Hanson does not own shares of any company mentioned in this article. FormFactor is a Hidden Gems recommendation. Corporate Executive Board is a Motley Fool Stock Advisor recommendation. No Fool is too cool for disclosure, not even Tim.