Investors aiming to balance growth potential and diversification in their portfolios often turn to small-cap exchange-traded funds (ETFs), which focus on companies with market capitalizations ranging from $250 million to $3 billion. These small-cap companies represent emerging firms that are beyond the microcap threshold but have not yet reached the scale of large-cap corporations exceeding $10 billion in market value. Due to their relatively smaller size and liquidity, they frequently receive less institutional scrutiny, creating opportunities—and challenges—for individual investors.
Small-cap ETFs aggregate a diversified basket of such companies, mitigating the risk inherent in investing in individual stocks, which can have higher failure rates. Notably, small-cap companies tend to demonstrate the capability for exponential growth, in contrast with established titans like Microsoft or Apple, whose size limits their capacity for doubling or tripling in value. By investing in small-cap ETFs, investors can capture the upside of emerging businesses while distributing risk.
Overview of Small-Cap ETFs
Small-cap ETFs typically track indices such as the Russell 2000 or the S&P 600, which represent the lower tier of public company market capitalizations. The Russell 2000 index, for example, includes approximately the bottom two-thirds of the broader Russell 3000 index, encompassing 3,000 large and small U.S. stocks. Other indices like the Wilshire 5000 offer a total market perspective, covering almost all publicly traded U.S. companies but still only around 3,500 stocks. These indices help define the scope of small-cap investment universes for ETF products.
Advantages and Disadvantages of Small-Cap ETFs
Advantages
- Higher Growth Potential: Small companies often have innovative business models or new market opportunities, allowing for rapid revenue and earnings expansion that larger firms may not achieve.
- Enhanced Diversification: Including small caps diversifies a portfolio beyond the major indices dominated by large caps, potentially reducing correlation and improving returns.
- Under-Analysed Opportunities: With limited analyst coverage compared to large caps, many small-cap stocks might be undervalued or unnoticed by institutional investors, which can benefit early retail investors.
- Agility: Small-cap companies can adapt quickly to changing market conditions or strategies, unlike larger firms burdened by bureaucracy.
Disadvantages
- Risk of Fraud and Manipulation: The limited scrutiny increases susceptibility to market abuses, including pump-and-dump schemes, especially in thinly traded stocks with low floats.
- Elevated Volatility: Small-cap stocks are marked by significant price swings, which can result in substantial fluctuations in portfolio value on a year-to-year basis.
- Economic Vulnerability: Unlike large-cap companies with established 'moats' and cash reserves, small caps may lack sufficient financial resilience, making them particularly sensitive to downturns or slow business cycles.
Criteria for Selecting the Best Small-Cap ETFs
When evaluating small-cap ETFs, important attributes include:
- Expense Ratios: Lower management fees contribute to better net performance over time.
- Liquidity: High trading volumes ensure ease of buying and selling at stable prices.
- Diversification: Broad holdings reduce company-specific risks and provide exposure across multiple sectors and sub-industries.
Leading Small-Cap ETFs for Various Investor Profiles
- Best Overall: Vanguard Small Cap Value ETF (VBR)
Tracks the CRSP U.S. Small Value Index with a focus on value metrics such as price-to-book and dividend yield, encompassing over 800 stocks. It features a low expense ratio of 0.07% and assets under management (AUM) of $13 billion. Weighted toward financials and industrials, it leans more toward the higher end of the small-cap range, including some mid-cap stocks. On average, approximately 300,000 shares trade daily, providing ample liquidity for investors. - Best for Active Traders: iShares Core S&P Small Cap ETF (IJR)
Boasting impressive liquidity and a competitive 0.07% expense ratio, IJR tracks the S&P Small-Cap 600 Index and maintains a carefully curated portfolio of about 602 stocks, excluding the smallest and least liquid names. Since its inception in 2000, it has grown to $41 billion in AUM, making it exceptionally attractive for active traders looking for volume and cost efficiency. - Best International Small-Cap Fund: Vanguard FTSE All World ex-U.S. Small Cap ETF (VSS)
This fund offers market-cap weighted exposure to small-cap stocks outside the U.S., including notable allocations to Japan (16%), Canada, and the U.K. While slightly more expensive at a 0.13% expense ratio, it manages over $5 billion in assets and trades about 230,000 shares daily. The average bid-ask spread of 0.11% reflects the relative illiquidity of international small-caps but remains reasonable. - Best Growth Fund: SPDR S&P 600 Small Cap Growth ETF (SLYG)
Focused on growth-oriented companies, SLYG tracks the S&P Small Cap 600 Growth Index with additional screening based on sales growth, earnings momentum, and price ratios. Despite a higher expense ratio of 0.15%, it commands over $2 billion in assets and maintains high liquidity with nearly 400,000 shares traded daily. - Best Value Fund: iShares Russell 2000 ETF
With holdings diversified across healthcare, financials, industrials, consumer discretionary, and information technology, this ETF covers 2,000 small-cap stocks. It aims to allocate 90% of assets to the underlying index's securities and depositary receipts. The expense ratio stands at 0.19%, somewhat higher than peers, but the broad exposure and steady returns make it worthy of consideration. - Best for Income: WisdomTree U.S. Small Cap Dividend ETF (DES)
Offering monthly dividend payouts, DES prioritizes dividend yield in its weighting, favoring sectors such as utilities, consumer discretionary, and real estate over technology and financials. With a 0.38% expense ratio and $2 billion AUM, it trades about 200,000 shares daily, reflecting a tradeoff of higher cost for consistent income streams within the small-cap space.
Strategic Considerations for Including Small-Cap ETFs
Incorporating small-cap ETFs into a portfolio can significantly enhance growth prospects over an extended investment horizon. However, investors must be prepared for elevated volatility and the distinct market dynamics of smaller companies. Allocating approximately 20% of an equity portfolio to small caps is a common approach to balance risk and reward while capitalizing on their growth advantages.
Ultimately, the selection of small-cap ETFs should align with individual investment goals, risk tolerance, and the desire for income or growth. Careful evaluation of fees, liquidity, and underlying holdings will help investors optimize their small-cap exposure efficiently.