Finding value despite the lower prices amid the coronavirus pandemic is still a challenge. Thus, many investors look to small caps for their low prices, but upside potential, but they must still be wary of the risks.

“The so-called small-cap effect, whereby small companies tend to outperform large ones over time is well documented,” a Trader’s magazine article noted. “The basic theory states that there is a premium to be achieved by investing in smaller companies. However, the challenge arises from the fact that the aforementioned small cap assets are usually a lot less liquid and are also a lot more volatile. In turn, transaction costs are higher and there is a greater risk of information leakage, impact on the underlying price as positions are slowly built up by active money managers.”

One other factor to consider is how small caps perform relative to large caps during a market downturn.

“Another key factor to consider when trying to harness the effect is a re-correlation risk,” the article added. “In other words, small caps will tend to outperform large caps, but when markets fall, small caps underperform large caps and depending on the severity of the overall market weakness, the risk of re-correlation to the broader market increases accordingly – i.e. ability to outperform large cap peers is reduced substantially. There are other biases to consider, but the basic outline of the theory is as above.”

For concentrated exposure in small caps, here are a few Vanguard funds to look at:

  1. Vanguard Small-Cap Index Fund ETF Shares (NYSEArca: VB): seeks to track the performance of a benchmark index that measures the investment return of small-capitalization stocks. The fund employs an indexing investment approach designed to track the performance of the CRSP US Small Cap Index, a broadly diversified index of stocks of small U.S. companies.
  2. Vanguard Small-Cap Value Index Fund ETF Shares (NYSEArca: VBR): seeks to track the performance of a benchmark index that measures the investment return of small-capitalization value stocks. The fund employs an indexing investment approach designed to track the performance of the CRSP US Small Cap Value Index, a broadly diversified index of value stocks of small U.S. companies.
  3. Vanguard Small-Cap Growth Index Fund ETF Shares (VBK): seeks to track the performance of a benchmark index that measures the investment return of small-capitalization growth stocks. The fund employs an indexing investment approach designed to track the performance of the CRSP US Small Cap Growth Index, a broadly diversified index of growth stocks of small U.S. companies.

A Factor-Based Small Cap Alternative

For investors looking to use factor-based strategies to enhance their small cap exposure, there’s the Goldman Sachs ActiveBeta U.S. Small Cap Equity ETF (GSSC). The fund seeks to provide investment results that closely correspond, before fees and expenses, to the performance of the Goldman Sachs ActiveBeta® U.S. Small Cap Equity Index. The index is designed to deliver exposure to equity securities of small capitalization U.S. issuers.

Additionally, the index is constructed using the patented ActiveBeta® Portfolio Construction Methodology, which was developed to provide exposure to the “factors” that are commonly tied to a stock’s outperformance relative to market returns. These factors include value, momentum, quality, and low volatility.

For more market trends, visit ETF Trends.