Small-Cap ETFs Can Offer Big Portfolio Benefits

November 8th at 8:01am by Tom Lydon

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.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.