Why Small Cap ETFs Have a Home In Your Portfolio

July 24, 2009 at 1:00 pm by Tom Lydon

Small cap stocks and companies can get overlooked by investors, as their large-cap counterparts may block the view. But good things come in small packages and exchange traded funds (ETFs) are a great tool to help get good small-cap exposure.

Despite the some of the criticisms lobbed at small caps, such as that they’re high-risk or lack quality, they have many good points. By definition, a small cap company has a market capitalization of $250 million to $2 billion. Those with a market cap below $250 million are referred to as micro-caps.

There are two benefits to using ETFs in order to get your small-cap exposure:

1. Although small cap companies can be tough to research, ETFs can do the legwork for you;

2. They invest in a number of companies at one time, so they spread the risk around

Other benefits of small cap stocks:

Lots of growth potential. Many large-cap companies were at one time small-cap companies. A modest investment can grow into a larger sum one day, explains Investopedia. Of course, don’t bank on this – just recognize the potential.
Mutual funds stay away. Most small-caps don’t have the market cap to support the size of investment that a mutual fund makes. Institutions can’t get into small- cap companies because they would buy up more than 20% of the company. This helps keep share prices even.
Under-recognized. The small- and micro-cap share gets little or no attention from Wall Street. Therefore, some feel that small-cap stocks are improperly priced, offering an opportunity to profit from the inefficiencies caused by the lack of coverage devoted to a particular area of the market.

Small caps also tend to perform well after a recession, as they are quick to adapt to shifting economic conditions. Small caps tend to trade at low multiples to book value and other fundamental measures, so they are desirable when investors are able to handle a bit of risk.