Small-Cap Index Funds: Performance & Investment Potential

Small cap index funds are made up of securities in companies that have a relatively small capitalization compared to the market standard. Every broker defines "small cap" differently. Most use a measure of capitalization somewhere between $200 million and $2 billion. Index funds that focus on these companies aim to capitalize on the notion that small cap stocks tend to outperform their counterparts year after year.

Small Cap Benefits

Small cap securities have several advantageous over their larger counterparts. They tend to be more responsive to market conditions. The companies may not be burdened by the same large infrastructure or large group of investors who can make change challenging.

Further, small cap stocks are more likely to be value stocks or under-traded stocks. This means they may trade at a price lower than the sum of their financial indicators. For example, a small cap Stock A has a very low beta, a high ROA and other beneficial features. Analysts determine it is worth $5 per share. However, Stock A is not very well-known due to its size, and is only trading at $3 currently. This gives investors a unique opportunity for profits.

Index Fund Benefits

An index fund manages risk by investing in a wide array of different securities then trading shares that represent each of those underlying assets. It is essentially a mutual fund, but it is designed to track only one market indicator. In this case, that indicator is small cap stocks. Unfortunately, mutual funds may not be able to purchase a large amount of shares in a single small cap issuer. To compensate for this limitation, these funds can purchase small amounts in a number of issuers, building an index entirely made up of small cap shares.

Small Cap Risks

With any potentially beneficial investment, there is always some risk. Companies with lower capitalization may be more apt to change to meet market conditions. On the other hand, they may be less able to withstand the blow of a market crash or a single large loss. As a result, these companies often have a higher risk of bankruptcy in an unfavorable market. Thankfully, the affect of one bankruptcy on an index fund should be rather negligible. By purchasing a fund instead of a high number of shares from a single issuer, you can diversify risk while still buying into only small cap stocks.

Other Value Stocks

There are a number of value stocks on the market that are not small cap. Anytime your broker analyzes a stock and determines it should be trading at a higher price, they have found a value stock. Value stocks tend to have a low trading volume. This means the market for the security is not well-developed. If you are not planning to sell anytime soon, buying a low-trading, value stock of any time can represent a high degree of capital appreciation in the future. Also, keep in mind ongoing dividend payments may be smaller than with a large cap, high-trading counterpart.