Exchange traded funds are a convenient way to get exposure to small-cap stocks while mitigating single-company risk. Small-cap ETFs typically focus on the bottom 10% of the market and can offer diversification benefits.

“Small-cap stocks tend to be more volatile because of narrower economic moats, greater sensitivity to macroeconomic risks, and less exposure to faster-growing international markets. But with this greater volatility comes a higher beta and the expectation for higher returns,” Michael Rawson wrote for Morningstar. [ETF Chart of the Day: U.S. Small Cap Funds]

Small-cap stocks are known for their growth potential, and have historically earned a return premium about 2.0% over large-cap stocks since 1926, reports Rawson. However, small-cap shares are known for the higher level of volatility and risk. Small-cap companies are qualified as those that have a market cap between $300 million and $2 billion. Since these companies are newer, thinly traded and are at risk of bankruptcy more than an established large-cap, they are considered risky. An ETF can help mitigate the risk a single company can pose and gives investors instant diversification. [Small-Cap ETFs]

Selena Maranjian for The Motley Fool reports that the iShares Core S&P Small Cap Index ETF (NYSEArca: IJR) costs are mere 0.16% and has beat the S&P 500 over the past three, five and ten years. Furthermore, U.S. small-cap equities have outperformed over the past decade, providing an annualized return of 7.3%, outpacing the large-cap equity returns (S&P 500) of 3.9% over the same period. [Investors Come out on Top in ETF Fee War]

The positive side of investing in small-cap companies is beneficial to a portfolio and can add a growth tilt. Investors must be able to stomach some volatility with companies of this size, but the reward should compensate. An investment in a small-cap ETF is best for the long term in order to realize the full potential.

Other small-cap ETFs:

  • Vanguard Small Cap ETF (NYSEArca: VB) cost :0.16%
  • iShares Russell 2000 Index (NYSEArca: IWM) cost: 0.26%
  • Schwab International Small Cap Equity (NYSEArca: SCHC) cost: 0.20%
  • Vanguard FTSE All-World ex-US Small-Cap Index ETF (NYSEArca: VSS) cost: 0.28%

iShares Core S&P Small Cap Index ETF

Tisha Guerrero contributed to this article.

Full disclosure: Tom Lydon’s clients own IWM.

Story updated to correct expense ratio for SCHC.

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