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Investing in new companies is inherently risky, but the potential for outsized gains is difficult to ignore. Established firms like Microsoft and Apple have become monoliths 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 1 or 2 companies (that you likely know very little about) isn’t a wise choice.
That’s where small-cap ETFs come in.
Best Small Cap ETFs:
- The Best Overall: iShares Russell 2000 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?
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 3,000 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 3,500 total stocks.
Pros and Cons of Small-Cap ETFs
As with anything, you’ll find pros and cons. Let’s go over the list of pros and cons with 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 1 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
Using the criteria listed above, Benzinga has chosen the best small-cap ETFs in 6 different categories.
1. Best Overall: 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 over 800 stocks. 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.
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.
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.
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 3 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 3 standards involving characteristics like sales growth, earnings change to price and momentum. It’s a little more expensive than others on the list at 0.15%. 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: iShares Russell 2000 ETF
The iShares Russell 2000 ETF‘s top holdings include a sector mix of healthcare, financials, industrials, consumer discretionary and information technology and includes companies like Penn National Gaming Inc., Sunrun Inc. and Caesars Entertainment Inc. As attractive as its steady-in-this-climate returns are, it trades these perks for its higher 0.19% expense ratio. Still, access to 2000 small-cap domestic stocks in a single fund and its aim to invest in 90% of its assets in securities of the underlying index and in depositary receipts makes it worth another glance.
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.
Get the Right Small-Cap ETFs for Your Portfolio
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.
Frequently Asked Questions
Are small-cap ETFs volatile?
Small-cap ETFs are volatile and prices fluctuate with the markets.
How much of my portfolio should be in small-cap ETFs?
You could invest 20% of your portfolio in small-cap ETFs to take advantage of the growth.