Small-cap stocks are more volatile and riskier compared with large-cap stocks, but they can provide diversification in a portfolio. These stocks derive earnings by selling products mostly in the U.S. unlike large-cap stocks that tend to be multinational companies, which receive a large portion of their revenue globally. Small caps also may be more sensitive to slowing growth, says Jodie Gunzberg, chief investment strategist of Graystone Consulting, a Morgan Stanley business. "Small caps have provided investors with a positive return premium over large caps," she says. "In order to earn the premium, the small caps selected need to have quality, measured by positive earnings." Here are seven top small-cap mutual and exchanged-traded funds
iShares Core S&P Small-Cap ETF
The iShares Core S&P Small-Cap ETF is a passively managed fund that follows the S&P SmallCap 600 Index (.SML) and is low cost and tax efficient. Small-cap funds which are part of a broader portfolio lower the amount of risk while adding stronger opportunities for growth, says R.M. Valdez, director of investments and portfolio manager at Partnervest Financial Group. "The opportunity for growth can be even more pronounced after a market pullback, as small caps tend to fall harder, but recover faster than large caps," she says. "Currently, we are utilizing two passive small-cap funds, including IJR because of its quality overlay in which stocks must have positive recent earnings."
iShares Russell 2000 Index
Another passively managed fund is IWM, which tracks the Russell 2000 benchmark index, the bottom two-thirds of small-cap stocks out of the index's 3,000. The top three holdings are Etsy (ETSY), Five Below (FIVE) and Cree (CREE), which are in the consumer discretionary and information technology sectors. The top three sectors in this index include financials, information technology and health care. The smallest holding is the consumer staples industry. This ETF gives investors the ability to trade options and is utilized by Partnervest Financial Group. "IWM's deep option market makes this ETF a viable candidate for a buy-write strategy," Valdez says.
Northern Small Cap Value Fund
The Northern Small Cap Value Fund (NOSGX) invests at least 80% of its net assets of small-cap companies within the range of the market capitalization of companies in the Russell 2000 Value Index (.RUJ) – between $300 million and $2 billion. The fund has about 53% of its stocks in the industrials, financials and real estate sectors. Many of the companies retain their earnings to finance current and future growth and generally pay little or no dividends. Small caps "typically don't move in lockstep with the market," says Mike Loewengart, chief investment officer at E-Trade Financial. "They don't come without their risks, but small caps can produce higher returns."
Vanguard Small-Cap Index Fund Admiral Shares
A popular choice in 401(k) plans, VSMAX provides a great deal of diversification with very low expenses. This mutual fund holds more than 1,300 stocks, which are primarily U.S. companies with only 0.2% in foreign holdings. The top holdings in this fund are Atmos Energy (ATO), IDEX (IEX) and Zebra Technologies (ZBRA). Basic materials, consumer goods, financials and technology are the top sectors in the fund. The portfolio consists primarily of small-sized companies and tracks the CRSP US Small Cap Index, an index designed to include firms with market capitalizations in the bottom 2% to 15% of the overall market.
Vanguard Small-Cap ETF
With a low expense ratio, the Vanguard Small-Cap ETF includes nearly 1,400 stocks. The portfolio tracks the CRSP US Small Cap Index, and some of its largest holdings are in financials, industrials and technology. This ETF has returned 5.56% over the past year and 12.77% over the past three years. Since this is an ETF, there are no minimum amounts required to make an investment and it is suitable for investors who chose to apply a dollar-cost averaging strategy, investing a set amount of money each month.
iShares Morningstar Small-Cap Value ETF
The iShares Morningstar Small-Cap Value ETF tracks the Morningstar Small Value Index, which is composed of small-capitalization U.S. equities that are value stocks. The fund invests at least 90% of its assets in securities of the underlying index. The underlying index measures the performance of stocks issued by small-cap companies that have exhibited value characteristics as determined by Morningstar's proprietary index methodology. The top holdings include Flex Ltd. (FLEX), TeraData (TDC), Bemis (BMS) and Ashland Global (ASH). The fund has more than 50% of its stocks in the financial, consumer discretionary and real estate sectors. Small caps can give exposure to less widely covered companies that may diversify from larger companies, Gunzberg says.
ProShares Russell 2000 Dividend Growers
A passively managed ETF, the ProShares Russell 2000 Dividend Grower tracks the performance of the Russell 2000 Dividend Growth Index (.RUO). The Russell 2000 Dividend Growth Index focuses on companies in the Russell 2000 Index (.RUT) that have increased dividend payouts every year for at least 10 years. The index contains a minimum of 40 stocks, which are equally weighted and broadly diversified across industry sectors. Each of the sector weights are capped at 30% of the index. The fund invested 25.23% in the utilities sector, 18.31% in the industrials industry and 16.52% in the financials sector.