Investing in new companies is inherently risky, but the potential for outsized gains is difficult to ignore.
Established firms like Microsoft and Apple have gotten huge and no longer have the potential to double or triple in size. Small-cap companies can grow exponentially and many aren’t yet in the clutches of institutional investors. Smaller firms do have a certain rate of failure, so investing in only one or two companies (that you likely know very little about) isn’t a wise choice. That’s where small-cap ETFs come in.
Quick Look: The Best Small Cap ETFs of This Year
- The Best Overall: Schwab U.S. Small Cap ETF
- The Best for Active Traders: iShares Core S&P Small Cap ETF
- The Best International Fund: Vanguard FTSE All-World ex-U.S. Small Cap ETF
- The Best Growth Fund: SPDR S&P 600 Small Cap Growth ETF
- The Best Value Fund: Vanguard Small Cap Value ETF
- The Best Fund for Income: WisdomTree U.S. Small Cap Dividend ETF
- What Are Small-Cap ETFs?
- Pros & Cons of Small-Cap ETFs
- Qualities of the Best Small-Cap ETFs
- The Best Small-Cap ETFs for This Year
- 1. Best Overall: Schwab U.S. Small Cap ETF (SCHA)
- 2. Best for Active Traders: iShares Core S&P Small Cap ETF (IJR)
- 3. Best International Fund: Vanguard FTSE All World ex-U.S. Small Cap ETF (VSS)
- 4. Best Growth Fund: SPDR S&P 600 Small Cap Growth ETF (SLYG)
- 5. Best Value Fund: Vanguard Small Cap Value ETF (VBR)
- 6. Best Fund for Income: WisdomTree U.S. Small Cap Dividend ETF (DES)
- Final Thoughts
What Are Small-Cap ETFs?
Small-cap companies are some of the newest public firms traded on exchanges, characterized by market capitalization between $250 million and $3 billion. Companies below $250 million are called microcaps, while large-caps come in at $10 billion or more. With a market cap over $250 million, companies signal to investors they have sufficient liquidity for trading.
Small-cap companies don’t get much analysis in financial publications and are largely ignored by institutional investors. This gives everyday investors a rare leg up on the sharks if they can tolerate the volatility.
Companies in this range tend to beat the S&P 500 over time but swing wildly from year to year. For example, here are the returns of small-caps during the dot-com bubble:
- 1999: 21.25% return
- 2000: -3.02% return
- 2001: 2.49% return
- 2002: -20.48% return
- 2003: 47.25% return
Several indexes track small-cap stocks, most notably the Russell 2000. The Russell 2000 is the bottom two-thirds of the larger Russell 3000 index, which tracks the largest 3000 publicly-traded companies in America.
Many ETFs track the Russell 2000, along with the S&P 600 and the Wilshire 5000. The Wilshire is a total market index of every publicly-traded company in America, which actually comes in below 3500 total stocks.
Pros & Cons of Small-Cap ETFs
Pros of Small-Cap ETFs
- More growth potential than large-cap stocks: Small-cap stocks are often new companies with exciting ideas and lots of room to grow. Stocks of this size are more likely to see exponential gains than large-cap companies.
- Extra diversification: ETFs give investors a basket of stocks in one security, but there are only 30 companies in the DJIA and 505 in the S&P 500. By opening up to smaller companies, you’ll be able to get diversification from the major indices that often move in lockstep with each other.
- Good companies unfairly ignored: Analyst coverage is lacking in the small-cap space, which allows plenty of quality companies to go unnoticed. That’s bad news for institutional investors, but good news for everyone else. Finding a great stock before the sharks get their teeth into it is a receipt for big returns.
- Flexibility: Small-cap companies are more nimble and open to change than established firms. Making wholesale pivots can be cumbersome for established firms; small-cap companies can recover quickly from missteps or change direction without fighting through onerous red tape.
Cons of Small Cap ETFs
- Ripe conditions for fraud: Lack of coverage from the financial media can be a double-edged sword as under-the-radar companies are often hotbeds for grifters and shady practices. Lightly traded small-caps with low floats are especially susceptible to pump and dump schemes.
- Increased volatility: As the data on returns shows above, small-cap stocks are prone to wild swings from year to year. Over time, small-caps beat large caps but the volatility from year to year might be too much for some investors to stomach.
- More susceptible to economic changes: Benjamin Graham wrote about investing in companies with large moats and margins of safety, something small-caps lack by definition. Due to their lack of cash reserves, slow business cycles or economic downturns can be devastating to small-cap stocks.
Qualities of the Best Small-Cap ETFs
The best small-cap ETFs will have:
- Low expense ratios
- Ample liquidity
- Diversification from major indices
The Best Small-Cap ETFs for This Year
Using the criteria listed above, Benzinga has chosen the best small-cap ETFs in six different categories.
1. Best Overall: Schwab U.S. Small Cap ETF (SCHA)
Charles Schwab has been upping the game with ETF products and its Charles Schwab U.S. Small Cap ETF is the best of the bunch. SCHA packs quite a punch. Cheap expense ratio, ample liquidity, and a portfolio completely separated from the S&P 500.
At 0.05%, the fund’s expense ratio is the best in the space. Even Vanguard’s cheapest small-cap fund comes in at 0.07%. SCHA tracks the Dow Jones U.S. Total Stock Market Small Cap index, which tracks the publicly traded companies ranked between 751 and 2500 in market cap.
Currently, the fund holds 1,750 small-cap stocks on a market-capitalization weighting. With $7.65 billion in assets under management and over 500,000 shares traded daily, you’re getting plenty of liquidity from a fund that’s matched its benchmark almost identically in the last five years.
2. Best for Active Traders: iShares Core S&P Small Cap ETF (IJR)
The iShares Core S&P Small-Cap ETF scores big points for its liquidity and costs, despite holding far fewer stocks than most ETFs on this list. It’s also more expensive than it’s Schwab counterpart.
However, you may struggle to find a small-cap ETF with more liquidity.
The 0.07% expense ratio isn’t the lowest, but it’s still a fair price for this type of exposure. IJR has been around since the dot-com bubble began deflating in 2000 and boasts an impressive $41 billion in assets today.
Additionally, the fund tracks the S&P Small-Cap 600 Index but cherry-picks its holdings. Currently, it only owns 602 stocks, excluding many of the smallest, most illiquid companies in the space.
Not only does this keep costs reasonable, but it gives IJR the most liquidity of any small-cap ETF (and as the chart shows, it’s beaten SCHA in the last few years).
3. Best International Fund: Vanguard FTSE All World ex-U.S. Small Cap ETF (VSS)
International small-cap funds can be difficult to buy (or own), but thankfully Vanguard has its FTSE All World ex-U.S. Small Cap ETF. The fund tracks the FTSE Global ex-U.S. Small Cap Net Tax Index, which provides a plain market-weighted exposure to international small-cap stocks.
The fund is a little more pricey than domestic options at a 0.13% expense ratio, but that’s still relatively cheap considering the stocks involved. Japan, Canada, and the United Kingdom are the three highest weighted countries, with Japanese stocks composing 16% of the fund’s holdings.
The fund has over $5 billion in assets under management and trades an average of 230,000 shares per day. Because of the illiquid nature for foreign small-caps, spreads for VSS average 0.11%. Still, in a space where international stocks get the last seat on the bus, the cost and liquidity of VSS is fair.
4. Best Growth Fund: SPDR S&P 600 Small Cap Growth ETF (SLYG)
For most small-cap investors, rapid growth is the goal. If you’re looking to get in on the ground floor of the most exciting new companies, turn your attention to the SPDR S&P 600 Small Cap Growth ETF. Yes, Standard and Poor is listed twice in the fund’s title, but this fund provides unique exposure to small-caps.
SLYG tracks the S&P Small Cap 600 Growth index with a couple of caveats. Stocks must meet three standards involving characteristics like sales growth, earnings change to price and momentum.
Currently, only 339 stocks are included in the fund. It’s a little more expensive than others on the list at 0.15%, but has handily beaten the S&P 500 since the Recession. Despite the small number of holdings, the fund still has over $2 billion in assets and trades nearly 400,000 shares per day on average.
5. Best Value Fund: Vanguard Small Cap Value ETF (VBR)
Small-cap value might seem like an oxymoron, but Vanguard has devised a fund capable of exposing investors to small-cap stocks based on different value factors, such as price-to-book ratio, debt-to-equity, cash flow, and dividend yield.
The Vanguard Small Cap Value ETF seeks to give investors large returns by focusing on the downtrodden names in the small-cap space.
Value has been beaten steadily by growth since the Great Recession, but VBR is still the best of the group thanks to its low 0.07% expense ratio and $13 billion in assets under management.
Unlike the other funds on this list, VBR tracks the CRSP U.S. Small Value index and holds 867 stocks as of December 2018. Financials (33% of holdings) and industrials (20%) are weighted more heavily here than in other comparable funds. On average, over 300,000 VBR shares are traded daily, giving it plenty of liquidity for traders.
Note that the fund leans more toward the higher market cap names in the space, including some stocks that qualify as midcaps.
6. Best Fund for Income: WisdomTree U.S. Small Cap Dividend ETF (DES)
There are plenty of opportunities for yield in small class stocks and the WisdomTree U.S. Small Cap Dividend ETF provides income without sacrificing too much growth.
DES has the highest expense ratio of any fund on our list at 0.38%, but that cost is offset somewhat because the fund pays dividends every month.
The fund follows the WisdomTree U.S. Small Cap Dividend index and weights its holding by dividend yield, not market capitalization. Safer, income-paying sectors like utilities, consumer discretionary and real estate are featured heavily in the fund, with less emphasis on tech and financials. Only $2 billion in assets are under management, but more than 200,000 shares are traded daily on average. The stock holds over 1,000 stocks and current distribution yield is a solid 3.4%.
Small-caps are much riskier than large caps in the short term, but history has shown that investors who can stomach the volatility are rewarded with outsized gains over longer time periods. Small-cap ETFs are a great starting point for any aggressively-tilted portfolio, although investors need to understand the risk/reward of this type of strategy before putting money into these relatively obscure companies.