Small-Cap Index Funds: Smart Investment Or Risky Move?

Small-cap index funds are a type of exchange-traded fund (ETF) that tracks an index of small-cap stocks. Small-cap stocks are among the most volatile equity investments, but they can also reward investors with higher growth rates than larger companies. Over the long term, small-cap index funds have delivered superior returns compared to large-cap funds. Small-cap stocks are often the stocks of young companies with smaller profits than more established companies, and they tend to be more sensitive to swings in the economy. Small-cap index funds are a good option for investors who want to gain broad exposure to small-cap stocks and benefit from portfolio diversification, risk reduction, bull market gains, and attractive growth potential.

Small-cap stocks: pros and cons

Small-cap stocks are a type of investment that can offer higher growth rates than their larger competitors. They are considered more volatile and risky but can be a good addition to an investment portfolio. Here are some pros and cons to help you decide if investing in small-cap index funds is right for you:

Pros:

• Potential for higher growth rates: Small-cap stocks have delivered superior returns over the long term compared to large-cap stocks.
• Diversification: Investing in small-cap index funds exposes your portfolio to a wide range of small-cap stocks across different sectors, reducing the risk associated with individual stocks.
• Bull market gains: Small-cap companies tend to outperform during bull markets when the stock market is on the rise.
• Attractive growth potential: Historically, small-cap stocks have outperformed large-cap stocks due to their greater growth potential.

Cons:

• Volatility and risk: Small-cap stocks tend to be more volatile and risky than large-cap stocks as they move cyclically with the broader economic cycle. They are also more sensitive to swings in the economy.
• Loss during market crashes: Due to their volatility, small-cap holdings are likely to lose more value during market crashes.
• Interest rate sensitivity: Small-cap stocks, especially those of smaller companies, are sensitive to interest rate changes as they rely more on debt than large-cap stocks.

Best small-cap index funds

Small-cap stocks are among the most volatile equity investments but can reward investors with higher growth rates than their larger competitors. Over the long term, small-cap index funds have delivered superior returns compared to large-cap funds.

Manning & Napier Rainier International Discovery Fund (RAIWX)

This fund mainly owns small-cap and mid-cap stocks traded outside the U.S. and is actively managed. It aims for sustainable growth from reasonably valued stocks at the time of purchase. The fund is heavily weighted towards industrial stocks, making up about 30% of the portfolio, with about 15% each in consumer discretionary names and technology stocks.

Schwab Fundamental U.S. Small Company Index Fund (SFSNX)

This fund tracks the Russell RAFI US Small Company Index and overweights components that are undervalued while also having strong relative growth and solid dividends. It has outperformed its Morningstar category over the past one, three, five, ten, and fifteen years. The fund's favourite sector is industrial stocks, followed by financials and consumer discretionary stocks.

Vanguard Tax-Managed Small Cap Admiral Fund (VTMSX)

This fund has a $10,000 minimum investment requirement, making it cost-prohibitive for some investors. It takes the S&P SmallCap 600 Index as its benchmark and favours industrials at about 17% of the portfolio, followed by financial stocks, technology, and consumer cyclicals.

Fidelity ZERO Extended Market Index Fund (FZIPX)

This fund tracks the Fidelity U.S. Extended Investable Market Index and has a zero expense ratio, making it one of the most affordable paths to capturing returns from the small-cap sector of the U.S. stock market. The fund's top holdings include financial stocks, industrials, tech stocks, healthcare, and consumer cyclical names.

Vanguard Russell 2000 Value Index Fund (VSIAX)

This fund may be hedging their bets by allocating a portion of their portfolio to mid-cap stocks. It has roughly 850 stocks with a solid earnings growth rate, with 22% of its shareholders' money in industrials and a little less in financials.

Vanguard Small Cap Growth Index Fund (VSGAX)

This fund provides access to the fastest-growing small-cap companies in the U.S., with an average market capitalization of about $7 billion. It has a projected average annual earnings growth rate of about 15% for the next three to five years, outperforming its Morningstar category. Nearly 30% of the portfolio is in the technology sector, with healthcare stocks and industrials as the second and third biggest groups.

IShares Russell 2000 Growth ETF

This ETF aims to track Russell 2000 stocks that exhibit growth characteristics. It has performed well in bull markets but also falls faster when stocks are down. It carries a reasonable expense ratio of 0.23%.

Schwab U.S. Small-Cap ETF

This ETF tracks the small-cap holdings of the Dow Jones U.S. Total Stock Market index and holds a mix of high-risk and low-risk stocks, providing diversification. It has a cheap expense ratio of 0.04% and a 10-year compound annual growth rate of 10.4%, including dividends. The fund's allocation includes 18% in industrials, 16% in financials, and 13% in healthcare. It also pays a dividend yield of 1.6% of the share price.

IShares Core S&P Small-Cap ETF

This is the biggest small-cap index fund on the market, with $71 billion in assets. It seeks to track the performance of the S&P Small Cap 600 index by holding a broad array of stocks and has outperformed the Russell 2000, posting an annual return of 12% with dividends. It has an expense ratio of 0.06% and offers a dividend yield of 1.6%.

Vanguard Small-Cap Value Index ETF

This ETF tracks the CRSP U.S. Small Cap Value index and, as a value-oriented index tracking fund, offers a dividend of 2.2% and an attractive expense ratio of 0.07%.

How to invest in small-cap index funds

Small-cap index funds are a type of exchange-traded fund (ETF) that tracks an index of small-cap stocks. Small-cap stocks are among the most volatile equity investments but can reward investors with higher growth rates than their larger competitors.

Step 1: Understand Small-Cap Index Funds

Before investing, it is important to understand the characteristics and risks associated with small-cap index funds. Small-cap stocks are typically defined as those with a market capitalization between $300 million and $2 billion. They are often young companies with smaller profits compared to more established businesses. Small-cap stocks tend to be more volatile and move cyclically with the broader economic cycle.

Step 2: Evaluate Your Investment Goals and Risk Tolerance

Consider your investment objectives, time horizon, and risk tolerance before investing in small-cap index funds. These investments are generally suitable for long-term goals and investors who can tolerate higher risk.

Step 3: Diversify Your Portfolio

Diversification is a key strategy when investing in small-cap index funds. By investing in a variety of small-cap stocks across different sectors, you can reduce the impact of individual stock performance on your portfolio. Diversified portfolios tend to perform better and are more resilient during market downturns.

Step 4: Choose the Right Small-Cap Index Fund

Research and compare different small-cap index funds before making a selection. Consider factors such as the fund's historical performance, fees, and the index it tracks. Look for funds with a strong track record, low expense ratios, and a focus on indices that align with your investment goals.

Step 5: Open an Investment Account

You will need a brokerage account to purchase small-cap index funds. Compare different brokers and choose one that offers a range of investment options, competitive fees, and tools that fit your investment strategy.

Step 6: Place Your Trade

Once you have selected a small-cap index fund and set up your brokerage account, you can place your trade. Decide on the amount you want to invest and whether you want to make a one-time investment or set up a regular investment plan (such as dollar-cost averaging).

Step 7: Monitor and Rebalance Your Portfolio

Regularly review the performance of your small-cap index fund investments and make adjustments as needed. Over time, the weightings of different stocks within the fund may change, and it may be necessary to rebalance your portfolio to maintain your desired level of diversification.

Some popular small-cap index funds include:

• IShares Russell 2000 Growth ETF
• Schwab U.S. Small-Cap ETF
• IShares Core S&P Small-Cap ETF
• Vanguard Small-Cap Value Index ETF
• Manning & Napier Rainier International Discovery Fund (RAIWX)
• Schwab Fundamental U.S. Small Company Index Fund (SFSNX)
• Vanguard Tax-Managed Small Cap Admiral Fund (VTMSX)
• Fidelity ZERO Extended Market Index Fund (FZIPX)

Small-cap index funds vs. large-cap index funds

Small-cap index funds and large-cap index funds are two of the most popular ways to slice and dice the investment universe. Small-cap funds invest exclusively in "small caps," or companies with a relatively small market capitalization, which is the total value of the company's outstanding shares. On the other hand, large-cap funds invest only in "large caps," or the biggest publicly traded companies.

Traits of Small Caps

Small caps are stocks with a market capitalization ranging from a few hundred million dollars to a few billion dollars. They have outperformed large caps over time and possess more growth potential due to their relatively small size. However, small caps have fewer financial resources, are generally less robust, and their stocks tend to be more volatile than those of larger companies. Typically, small companies pay dividends less frequently and need to reinvest their profits for growth.

Traits of Large Caps

Large caps are stocks with a valuation of over $10 billion, although those above $200 billion are sometimes called mega-caps. They are considered safer investments than small caps and have a strong track record of performance. Large caps tend to have less growth potential as they operate in mature industries and have limited expansion opportunities. These stocks have deep financial resources and are generally financially robust, making them less volatile than small caps. Stocks of large companies usually have multiple business lines, giving them greater business strength and resilience. Large caps often pay out a significant portion of their profits as dividends since they require less of their earnings to fuel growth.

Performance and Volatility

While it's important to understand the differences between small caps and large caps, some of these differences become less pronounced when they are combined into a fund. For example, while individual small-cap stocks may be quite volatile, a fund of small caps is much less volatile. Similarly, while individual small caps can vastly outperform large caps, a collection of small caps tends to perform better, but the difference is less pronounced.

Data from Portfolio Visualizer shows that from 1972 through May 2022, small caps outperformed large caps by a full percentage point. This difference may seem insignificant at first, but over time, it translates into a substantial wealth gap. If you had invested $10,000 in each category in 1972, it would have grown to $1.52 million in large caps but a significantly higher $2.47 million in small caps.

The higher returns of small caps come with greater volatility. The standard deviation for small caps indicates that they are much more volatile than large caps. However, this volatility can lead to years of exceptional performance. For instance, the best year for small caps saw them rise more than 55%, compared to 37.5% for large caps.

In recent years, large-cap stocks have outperformed small-cap stocks, with tech giants like Nvidia, Microsoft, and Apple driving a large portion of market returns. Over the past decade, the Russell 1000 Index (large-cap companies) has seen annualized returns of about 12.4%, while the Russell 2000 Index (small-cap companies) has returned around 7.4%.

Balancing Small-Cap and Large-Cap Funds in Your Portfolio

When deciding how to allocate your portfolio between small-cap and large-cap funds, consider the following factors:

• Overall stability: Large caps provide a solid foundation for any portfolio due to their financial and business strength, and their returns have been consistently strong over time.
• Size of the market: Large caps constitute a much larger portion of the stock market, so it may be challenging to build a diverse portfolio without including some large-cap funds.
• Diversification: Including both types of stock funds reduces risk. Many advisors advocate having a larger exposure to large-cap funds due to their stability.
• Point in the economic cycle: Small-cap funds tend to perform well when the market is recovering from a recession. As the economy booms or slows, investors tend to favor large caps for their stability and dividends.
• Need for income: If you're seeking dividend income, large-cap funds are likely preferable due to the financial strength of the underlying companies.
• Aggressive vs. conservative investing: If you're inclined towards aggressive investing, consider increasing your allocation to small-cap funds. Conversely, if you prefer a more conservative approach, opt for a higher proportion of large caps.
• Your age: Your age can indicate how conservative or aggressive you want to be with your investments. If you have a long investment horizon, you may tolerate more risk by allocating more to small-cap funds.
• Value vs. growth funds: Small-cap and large-cap funds can be further categorized into value or growth funds, and each type performs differently in varying market conditions.
• Expense ratio: The expense ratio is the cost of owning a fund relative to your investment in it. Small-cap funds often charge higher fees due to the extensive analysis required to identify and invest in suitable stocks. In contrast, large-cap funds can be very affordable, often charging under 0.10% annually.

While small-cap and large-cap funds offer distinct advantages, it's essential to recognize that there is considerable variation within each category. Therefore, investors should carefully evaluate a fund's investments, mandate, track record, and other specifics before making investment decisions.

Outlook for small-cap index funds

Small-cap index funds are a type of exchange-traded fund (ETF) that tracks an index of small-cap stocks. Small-cap stocks are considered highly volatile equity investments, but they can offer investors the potential for higher growth rates than larger companies. Over the long term, small-cap index funds have delivered superior returns compared to large-cap funds.

Small-cap companies are often young companies with smaller profits than their more established counterparts. Small-cap index funds provide investors with exposure to a broad range of small-cap stocks across different sectors, which can enhance portfolio diversification and reduce risk. These funds tend to outperform during bull markets, and historically, small-cap stocks have outperformed large-cap stocks.

However, due to their volatility, small-cap holdings tend to lose more value during market crashes. For example, during the March 2020 crash caused by the COVID-19 pandemic, small-cap stocks fell faster than the broader market.

Despite the risks, small-cap stocks can be attractive investment opportunities, especially when they are trading at a discount relative to their historical averages. As of late 2023, small-cap stocks were considered "bargain-priced" by some analysts, presenting a good opportunity for investors to diversify their portfolios.

When considering small-cap index funds, it is essential to evaluate the fund's performance, fees, and investment strategy. Some popular small-cap index funds include the iShares Russell 2000 Growth ETF, Schwab U.S. Small-Cap ETF, and Vanguard Small-Cap Value Index ETF.

In summary, small-cap index funds can be a valuable component of an investment portfolio, offering the potential for higher growth rates and portfolio diversification. However, investors should be mindful of the risks associated with the volatility of small-cap stocks.

Frequently asked questions