What Are Small-Cap ETFs?

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The stock market is full of different asset classes and investment opportunities new investors might not recognize. While shares in large, industry-leading companies like Alphabet and Tesla often garner the most attention, less-publicized stocks can be just as promising. Small-cap ETFs are an excellent example.

A small-cap ETF, like other exchange-traded funds, is a security that tracks an index of various stocks. What sets small-cap ETFs apart from other funds is their size. As the name suggests, these funds invest in small-cap stocks, which have a market cap between $300 million and $2 billion.

When you invest in a small-cap ETF, you indirectly invest in multiple smaller companies without searching for and buying their individual stocks. Here’s a closer look at their advantages, risks, and some real-world examples.

Advantages of Small-Cap ETFs

The primary advantage of an ETF is that they help diversify your portfolio, since you invest in multiple companies at once. This diversification can help lessen the blow of poor performance in any one company or sector.

Investing in small-cap ETFs comes with some unique benefits. Since smaller companies are more likely to experience exponential growth, their stocks likewise grow faster than large-cap stocks. This quick growth can lead to impressive returns for comparatively small upfront investments.

Small-cap ETFs also typically outperform during bull markets since smaller companies generally rise and fall with the overall economy. Considering how nearly $10 trillion in business value is transitioning over the next decade, there’s a lot of potential for growth. If markets do turn sour, small-cap ETFs aren’t likely to cause dramatic losses, either, since they’re often cheaper from the start.

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Things to Consider With Small-Cap ETFs

Like any investment, small-cap ETFs also carry a few risks. Most notably, small-cap stocks are more volatile than larger companies, given their size and higher subjectivity to the broader market. So, while they have more potential for exponential growth, they also have more potential to crash.

For example, some small-cap ETFs fell by as much as 40% in the March 2020 crash, whereas larger funds fell by around 33%. Since small-cap ETFs invest in smaller companies, market crashes affect them more heavily. Still, these ETFs also rebounded quicker than many larger stocks towards the end of 2020.

Small-cap companies also eventually hit a growth limit, since their market caps won’t be small anymore after enough growth. As a result, small-cap ETFs may not be able to hold on to top performers for extended periods.

Small-Cap ETF Examples

Perhaps the most noteworthy small-cap ETF is the iShares Russel 2000 Growth ETF (IWO). This fund tracks the Russel 2,000 Index, made of the smallest 2,000 companies in the Russel 3,000. It’s become one of the most popular small-cap ETFs due to its comparatively high diversity and impressive historical performance, with a CAGR of nearly 14% over the last decade.

Another popular small-cap ETF is the Vanguard Small-Cap Growth ETF (VBK). It follows the CRSP U.S. Small Cap Growth Index, another large, all-encompassing index. Like IWO, it’s shown strong, consistent performance, growing 20% a yearover the last five years.

Unlike growth-oriented funds like IWO and VBK, The Shwab U.S. Small-Cap ETF (SCHA) aims for a mix of low- and high-risk stocks. These investments, which are all in the Dow Jones U.S. Small-Cap Total Stock Market Index, may provide more diversification than some other ETFs. This, along with its low expense ratio of 0.04%, has made it a popular choice for many investors.

Make the Most of Your Investment Portfolio

Small-cap ETFs provide a unique opportunity for diversifying your investment portfolio. While they may be riskier than other investments, their growth potential and affordability make them an enticing option. Understanding these securities and what they offer will help you make more informed investment decisions in the future.

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