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Why You Should Consider Small-Cap Index Funds

Ellen Chang

Small-cap funds are often ignored because of its volatility, but it can reward investors with a higher rate of return over a long period.

While small-cap stocks are riskier compared to large-cap stocks, these stocks offer additional diversification in a portfolio.

"Small-cap equities are great because we know that over the long run an investor can earn somewhere near an extra 4% per year in returns as compared to large caps," says Derek Horstmeyer, an assistant finance professor at George Mason University in Fairfax, Virginia. "The downside is the definite increase in volatility that one has to take on."

Small-cap index funds can be a good addition to an investor's portfolio, says Stuart Michelson, a finance professor at Stetson University.

"An investor should not solely invest in small-cap funds, but adding small-cap funds to a diversified portfolio of large-cap, mid-cap and S&P index funds will benefit an investor by providing a good risk and return balance," he says.

Here are a few trends within small-cap index funds:

-- Small caps can outperform large-cap stocks.

-- Small caps can be volatile.

-- Investors should hold some small-cap funds.

Small Caps Can Outperform in the Long Term

Small-cap stocks derive earnings by selling services and products mostly in the U.S. compared to large-cap stocks, which tend to be more global. These companies perform differently from large caps due to their unique small business characteristics, says Jodie Gunzberg, chief investment strategist of Graystone Consulting, a Morgan Stanley business.

"They generally have a higher beta and are more cyclical than large caps, so they have done historically better in up markets, gaining on average 1.2% for every 1% large caps gained," she says. "Their revenues are mainly driven domestically so they have done better with growth domestic product growth, a rising dollar and inflation."

[See: 8 Investing Do's and Don'ts During Market Volatility.]

During longer periods small-cap stocks have outperformed large-cap stocks, says Gary Lemon, an economics and management professor at DePauw University.

"Over 20 years, this difference would lead to a substantial difference in your portfolio," he says. "If $10,000 were invested at these rates, at the end of 20 years in a large-cap fund you would have $63,700 versus $100,000 is a small-cap fund, or 57% more money."

Small caps tend to "persistently under-perform late in the macroeconomic cycle when margin pressures build since they tend to be more exposed to rising cost pressures and margin headwinds," Gunzberg says.

"Currently, we prefer large caps over small caps since we think we are late in the cycle," she says. "Given our negative view on the operating environment for U.S. equities in 2019, we are not surprised that small caps have been persistently under-performing since June 2018.

But research has shown that small-cap funds are one segment where mutual fund managers are able to outperform the index, although expense ratios and trading costs will be higher, directly affecting profitability, Lemon says.

"When reviewing historical performance, one can observe returns ranging from -3% to +25% over the past few years, thus riskier than large-cap funds, but they still provide nice diversification," he says.

There are many low-cost options for small-cap funds, such as the Vanguard Small-Cap Growth Index ( VISGX), Vanguard SmallCap Value Index ( VISVX), Vanguard Small Cap Index Fund ( NAESX) and Fidelity Small-Cap Index fund ( FSSNX), Michelson says. All of these funds are low cost, with expense ratios less than 0.2%.

Small Caps Can Be Volatile

Small-cap stocks are often more volatile because when growth shrinks, these companies are impacted sooner, says Gunzberg. Small caps are less defensive, more leveraged and more impacted by a falling dollar.

"Labor cost pressures appear to be having a greater impact on small businesses now and the initial boost from tax cuts and tariffs seem to be fading," she says. "Relative earnings growth has dropped for small caps and when these stocks do not have strong earnings historically will lose their premium over large caps."

[See: 7 Great ETFs to Invest in Money.]

These stocks historically perform better in rising markets when there is stronger growth along with a strong dollar, rising interest rates and inflation, Gunzberg says.

"They are more cyclical, sensitive to domestic economic factors and shielded from international issues," she says.

During shorter periods, small-cap stocks can produce losses. In 2008, for example, an investor would have lost 36.1% in small-cap stocks and in 2015, a portfolio would have lost 5.5% while the S&P 500 was up 1.4%, Lemon says.

"Of course, there is no free lunch," he says. "This why it is important to have a long-run view when investing in small-cap stocks."

Small-cap stocks will perform better in up markets and will fare worse in down markets generally, Lemon says.

"Whatever is driving the market as a whole will also be driving small-cap stocks," he says. "The implication is that in an upmarket, small-cap stocks will probably perform better than large-cap stocks and will fare worse in down markets."

A heavier exposure to small caps can insulate investors from international risk such as trade disputes, says Mike Loewengart, chief investment officer at E-Trade Financial, a New York-based brokerage company.

Investors Should Hold Some Small-Cap Funds

Purchasing funds in a sector can be tricky. Some experts recommend a smaller percentage such as 5% while others believe that only a larger stake will impact the returns in a portfolio.

Lemon says his rule of thumb is to invest between 5% and 20% of a portfolio in a sector.

"If you invest less than 5%, it is not worth the effort to find the right mutual fund," he says. "On the other hand, unless you are young and can ride out large market corrections and you want to be very aggressive, then 20% is the upper limit for most investors."

Two benchmarks track small-cap companies -- the Russell 2000 and the S&P SmallCap 600. The Russell 2000, commonly referred to as RUT, tracks about 2,000 small-cap companies, with market capitalization between $300 million and $2 billion.

While the Russell 2000 is more popular and commonly used, the S&P SmallCap 600 removes negative earnings and is not a passive index, Gunzberg says. The eligibility requirements are stricter and companies are only included if they generate positive net income over the previous 12 months, including the most recent quarter.

Small-cap companies receive less coverage by analysts. Small-cap funds charge a higher fee because they are actively managed, Loewengart says.

"You're essentially paying a portfolio manager to do some digging into these typically lesser-known companies and make calls on how they're going to grow," he says. "With small-cap exchange-traded funds, investors should be looking to track a broad-based small-cap index such as the Russell 2000 or S&P 600."

The amount of risk and an investor's age should "really determine how much of a weight to put on small-cap indices," Horstmeyer says.

[7 Signs It's Time to Sell an Investment.]

"If you are young and risk-seeking and have a long investment horizon, then I would say it's safe to allocate 10% or even more to small caps in your portfolio," he says.

Although investors who can cope with more risk could allocate 30% of a diversified portfolio in small-cap funds or ETFs, Michelson says.

"If an investor is more risk-averse, they should consider investing only 5% to 10% of their portfolio in small-cap index funds," he says.

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