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There are at least two good reasons why most investors invest a portion of
their portfolios in small cap stocks:
 | Small-Cap stocks may have better long-term risk-adjusted returns than
large-cap stocks.
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| Small-Cap stocks have relatively low correlations with large-cap stocks,
so including them in an otherwise large-cap stock portfolio should improve the
portfolio's risk/return characteristics. |
There are several similar-seeming investment options
available. Which is best?
All of the options discussed here will likely have somewhat similar performance
and any of them will probably get the job done quite well. You can't go far wrong choosing any
of the options listed here. However, there is a dramatic difference
between how funds investing in the absolute tiniest stocks perform versus
those investing in merely "small" stocks. The funds are listed in rough overall
order of preference.
Preferences are listed separately for use in
retirement accounts and for taxable accounts.
For a listing of our preferences in other asset classes, see
here.
Retirement Accounts (i.e., tax-deferred or tax-exempt accounts)
| Bridgeway Ultra-Small Company Market Fund (BRSIX). E/R: 0.65%.
This fund basically tries to track the CRSP 10 index, which is an index of all domestic stocks whose market
capitalization is in the bottom decile of stocks traded on the New York Stock
Exchange. The fund
is tax-managed to minimize capital gains distributions, but this shouldn't
preclude it from being used in a retirement account. The expense ratio
looks high, but isn't, considering the extreme smallness of the stocks it
invests in. Compared to peer funds (i.e., those investing in ultra-small
cap stocks), it is quite low. This fund charges a 2% redemption fee for
shares sold within six months of purchase. That fee is paid directly to
the fund in order to provide a disincentive for market-timers. As of
12/31/08, this fund's weighted average market capitalization was 79%
smaller than the Vanguard Small Cap Index Fund's (NAESX) and 53% smaller than
the DFA US Micro Cap Portfolio (DFSCX).
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| iShares Microcap Index Fund (IWC). E/R: 0.60%. This ETF
tracks the Russell Microcap Index (the 1000 smallest stocks of the Russell
2000 index, plus the next 1000 largest stocks smaller than those in the
Russell 2000 index). We expect the NAV-mkt
tracking error to be quite large for this fund, due to the extreme illiquidity
of the underlying stocks. For more information on ETFs, see
here.
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| DFA US Micro Cap Portfolio (DFSCX). E/R: 0.54%. This
fund has the second-lowest weighted-average market capitalization of any
passively managed fund we are aware of. It basically has a strategy of
buying stocks of companies whose market capitalizations are generally in the
lowest 5% of total market capitalization, or companies whose market
capitalizations are smaller than the 1,500th largest US company -- whichever
results in a higher market cap break. As of 12/31/08, this fund's
weighted average market capitalization was 55% smaller than the Vanguard
Small Cap Index Fund's (NAESX). Unfortunately, this fund is closed to
new investors.
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| First Trust Dow Jones Select MicroCap Fund (FDM). E/R:
0.60%. This ETF tracks the
Dow Jones Select Microcap Index. We expect the NAV-mkt
tracking error to be quite large for this fund, due to the extreme illiquidity
of the underlying stocks. For more information on ETFs, see
here.
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| Vanguard Small Cap ETF (VB). E/R: 0.15%. This ETF is a
share class of the Vanguard Small Cap Index Fund (NAESX). As such, it
should benefit from greater internal efficiency that incoming cash flows
bring, as compared with other ETFs. For more information on ETFs, see here.
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| Vanguard Small Cap Index Fund (NAESX). E/R: 0.28%. This
fund tracks the MSCI US Small Cap 1750 Index. While its expense ratio is
lower than BRSIX and DFSCX above, the stocks it invests in are nowhere near as
small.
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| Schwab U.S. Small-Cap ETF (SCHA). E/R: 0.13%. This ETF
tracks the Dow Jones U.S. Small-Cap Total Stock Market Index. For more information on ETFs, see here.
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| DFA US Small Cap Portfolio (DFSTX). E/R: 0.40%. This
fund essentially tracks the CRSP 6-10 index, which is an index of all domestic
stocks whose market capitalization is in the bottom half of stocks traded on
the New York Stock Exchange. Given the above better alternatives, we see
little reason to buy this fund.
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| iShares S&P Small Cap 600 Fund (IJR). E/R: 0.20%. This
ETF tracks the S&P Small Cap 600 index. For more information on ETFs,
see here.
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| iShares Russell 2000 Fund (IWM). E/R: 0.20%. This ETF
tracks the Russell 2000 index. For more information on ETFs, see
here.
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| iShares Morningstar Small Core Fund (JKJ). E/R: 0.25%. This ETF
tracks all stocks which Morningstar considers to be "Small Core." For more information on ETFs, see
here.
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| WisdomTree SmallCap Earnings Fund (EES). E/R: 0.38%.
This is an ETF which tracks the WisdomTree SmallCap Earnings Index. This
index is built by removing the 500 largest (by market cap) companies in the
WisdomTree Earnings Index of positive earnings companies and then
removing the 75% largest market capitalization companies of those remaining.
The index weights the remaining companies by the cash value of their earnings.
The WisdomTree SmallCap Earnings Index is a non-cap weighted index of US small
cap stocks. We like its non-cap weighting. This should result in
somewhat increased pre-expense returns over time. However,
the high expense ratio and relative illiquidity costs (i.e., bid-ask spreads)
of new ETFs such as this
cause us pause at this time. Further, we are concerned that this fund
holds a relatively large percentage of its assets in REITs (which we consider
to be a separate asset class) and the stocks that the fund buys simply aren't
very small. For more information on ETFs, see here.
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| WisdomTree SmallCap Dividend Fund (DES). E/R: 0.38%.
This is an ETF which tracks the WisdomTree SmallCap Dividend Index. This
index is built by removing the 300 largest (by market cap) companies in the
WisdomTree Dividend Index of regular dividend paying companies and then
removing the 75% largest market capitalization companies of those remaining.
The index weights the remaining companies by the cash value of their dividend
payouts.
The WisdomTree SmallCap Dividend Index is a non-cap weighted index of US small
cap stocks. We like its non-cap weighting. This should result in
somewhat increased pre-expense returns over time. However,
the high expense ratio and relative illiquidity costs (i.e., bid-ask spreads)
of new ETFs such as this
cause us pause at this time. Further, we are concerned that this fund
holds a relatively large percentage of its assets in REITs (which we consider
to be a separate asset class) and the stocks that the fund buys simply aren't
very small. For more information on ETFs, see here.
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| Schwab Fundamental US Small-Mid Company Index Fund (SFSVX). E/R: 0.59%.
This fund tracks the FTSE RAFI 1500 US Small-Mid Index, a non-cap weighted
index of US small cap stocks. The high expense ratio precludes this being a good choice. Two
lower cost share classes are available for higher minimum dollar amounts, but
even those are too expensive, given the less expensive small cap choices above.
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| PowerShares FTSE RAFI US Small-Mid Portfolio (PRFZ). E/R: 0.60%.
This is an ETF which tracks the FTSE RAFI 1500 US Small-Mid Index, a non-cap weighted index of US
small cap stocks. The
high expense ratio and relative illiquidity costs of new funds such as this
cause us pause at this time. For more information on ETFs, see here. |
| iShares Microcap Index Fund (IWC). E/R: 0.60%. This ETF
tracks the Russell Microcap Index (the 1000 smallest stocks of the Russell
2000 index, plus the next 1000 largest stocks smaller than those in the
Russell 2000 index). We expect the NAV-mkt
tracking error to be quite large for this fund, due to the extreme illiquidity
of the underlying stocks. For more information on ETFs, see
here.
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| Bridgeway Ultra-Small Company Market Fund (BRSIX). E/R: 0.65%.
This fund basically tries to track the CRSP 10 index, which is an index of all domestic stocks whose market
capitalization is in the bottom decile of stocks traded on the New York Stock
Exchange. This fund
charges a 2% redemption fee for shares sold within six months of purchase.
That fee is paid directly to the fund in order to provide a disincentive for
market-timers. As of
12/31/08, this fund's weighted average market capitalization was 68% smaller
than DFTSX below and 76% smaller than VTMSX below. The fund is
tax-managed to minimize capital gains distributions, but this shouldn't
preclude it from being used in a retirement account.
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| First Trust Dow Jones Select MicroCap Fund (FDM). E/R:
0.60%. This ETF tracks the
Dow Jones Select Microcap Index. We expect the NAV-mkt
tracking error to be quite large for this fund, due to the extreme illiquidity
of the underlying stocks. For more information on ETFs, see
here.
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| DFA Tax-Managed US Small Cap Portfolio (DFTSX). E/R: 0.55%.
This fund essentially tracks the CRSP 6-10 index, which is an index of all
domestic stocks whose market capitalization is in the bottom half of stocks
traded on the New York Stock Exchange. The fund manages to minimize
dividends as well as capital gains.
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| Vanguard Tax-Managed Small-Cap Fund (VTMSX). E/R:
0.19%. This fund tracks the S&P Small Cap 600 index while minimizing capital gains
AND dividend distributions. Unfortunately, the fund's
short-term redemption fees (1% for redemptions in the first five years after
buying) limit opportunities for otherwise
beneficial tax-loss
harvesting and rebalancing.
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| Vanguard Small Cap ETF (VB). E/R: 0.15%. This ETF is a
share class of the Vanguard Small Cap Index Fund (NAESX). As such, it
should benefit from greater internal efficiency that incoming cash flows
bring, as compared with other ETFs. However, unlike other ETFs,
Vanguard ETFs are only as tax efficient as their underlying fund, no more and no
less. For more information on ETFs, see here.
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| Vanguard Small Cap Index Fund (NAESX). E/R: 0.28%. This
fund tracks the MSCI US Small Cap 1750 Index. The fact that this fund
has an ETF share class should make it somewhat more tax-efficient than it
otherwise would be.
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| Schwab U.S. Small-Cap ETF (SCHA). E/R: 0.13%. This ETF
tracks the Dow Jones U.S. Small-Cap Total Stock Market Index. For more information on ETFs, see here.
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| iShares S&P Small Cap 600 Fund (IJR). E/R: 0.20%. This
ETF tracks the S&P Small Cap 600 index. While ETFs tend to be
extremely capital gains tax efficient, the costs associated with
reconstitution have tended to cause their performance to be inferior to
similar non-ETFs (like NAESX above). For more information on
ETFs, see here.
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| iShares Russell 2000 Fund (IWM). E/R: 0.20%. This ETF
tracks the Russell 2000 index. While ETFs tend to be extremely capital
gains tax efficient, the costs associated with reconstitution have tended to
cause their performance to be inferior to similar non-ETFs (like NAESX above). For more information on ETFs, see
here.
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| iShares Morningstar Small Core Fund (JKJ). E/R: 0.25%. This ETF
tracks all stocks which Morningstar considers to be "Small Core." For more information on ETFs, see
here.
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| WisdomTree SmallCap Earnings Fund (EES). E/R: 0.38%.
This is an ETF which tracks the WisdomTree SmallCap Earnings Index. This
index is built by removing the 500 largest (by market cap) companies in the
WisdomTree Earnings Index of positive earnings companies and then
removing the 75% largest market capitalization companies of those remaining.
The index weights the remaining companies by the cash value of their earnings.
The WisdomTree SmallCap Earnings Index is a non-cap weighted index of US small
cap stocks. We like its non-cap weighting. The high expense ratio and relative illiquidity costs (i.e., bid-ask spreads)
of new ETFs such as this
cause us pause at this time. Further, we are concerned that this fund
holds a relatively large percentage of its assets in REITs (which we consider
to be a separate asset class) and the stocks that the fund buys simply aren't
very small. For more information on ETFs, see here.
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| WisdomTree SmallCap Dividend Fund (DES). E/R: 0.38%.
This is an ETF which tracks the WisdomTree SmallCap Dividend Index. This
index is built by removing the 300 largest (by market cap) companies in the
WisdomTree Dividend Index of regular dividend paying companies and then
removing the 75% largest market capitalization companies of those remaining.
The index weights the remaining companies by the cash value of their dividend
payouts.
The WisdomTree SmallCap Dividend Index is a non-cap weighted index of US small
cap stocks. The relative illiquidity costs (i.e., bid-ask spreads)
of new ETFs such as this
cause us pause at this time. Further, we are concerned that this fund
holds a relatively large percentage of its assets in REITs (which we consider
to be a separate asset class) and the stocks that the fund buys simply aren't
very small. For more information on ETFs, see here.
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| PowerShares FTSE RAFI US Small-Mid Portfolio (PRFZ). E/R: 0.39%.
This is an ETF which tracks the FTSE RAFI 1500 US Small-Mid Index, a non-cap weighted index of US
small cap stocks. The
relative illiquidity costs of new funds such as this
cause us pause at this time. For more information on ETFs, see here.
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| Schwab Fundamental US Small-Mid Company Index Fund (SFSVX). E/R: 0.59%.
This fund tracks the FTSE RAFI 1500 US Small-Mid Index, a non-cap weighted
index of US small cap stocks. The high expense ratio precludes this being a good choice. Two
lower cost share classes are available for higher minimum dollar amounts, but
even those are too expensive, given the less expensive small cap choices above.
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