The Many Possible ETFs
When investors get started, it is often recommended that they take the road of passive investing over a more active approach, as it requires less knowledge and experience. This way, even someone paying little attention to stock markets, or with little understanding of them, can get exposure and compound his capital over time.
Nowadays, this usually translates to broad exposure to large ETFs (Exchange-Traded funds) replicating the performance of dozens, or even hundreds, of the largest companies, for example, following the S&P500 or the Nasdaq. Doing so provides a very high level of diversification despite a simple approach and very low trading fees.
(You can learn more about this topic in our articles “ETFs Vs. Stocks: Which Should You Invest In?” and “Investing in ETFs (How To Pick The Best ETF)”).
There are thousands of possible ETFs to pick from. This allows for an investing approach that could be called semi-passive. It still does not require picking individual stocks, but a portfolio can be built with the desired exposure to specific sectors, creating an active approach to the sector but a passive one to the individual stock selected.
For example, you can add commodities ETFs, gold ETFs, energy ETFs, aerospace ETFs, cannabis ETFs, etc. And build a more intentional and still very diversified portfolio.
Small Versus Large Caps
Another possible selection method other than aiming by sectors is the size of companies. During some periods, larger companies outperform the rest of the market. Among others, smaller companies perform best.
In that perspective, the market can be divided between large companies (large “caps” – standing for “capitalization”) and small caps, typically firms with market capitalization between $300M and $2B.
As a rule of thumb, large caps tend to outperform during speculative periods, where enthusiasm about endless growth abounds, even for the largest companies. And this has been the case in the past decade, with small caps lagging behind, even if they provided decent returns in absolute terms.
Source: Advisor Perspective
In contrast, the smaller companies, with more space to grow or are active in specific niches, tend to perform better during periods of market instability. So, after a massive boom in tech megacaps and large global corporations, driven by the narrative around AI adoption, it could soon be the turn for small caps to shine.
Investors should, however, be aware that even in periods of outperformance, small caps index tend to be a lot more volatile than large companies.
Source: RBC Wealth Management
Small Cap ETFs
If it is difficult to pick stocks with large companies, it is even more so with smaller companies. This is because they will generally have characteristics that make them harder to analyze:
- Active in smaller markets, or technical niches.
- Less, or maybe even no coverage by independent analysts.
- Smaller access to capital or technological advantage.
- Management is often less communicative toward investors.
This is why small cap ETFs can be a good option to get exposure to the sector without having to personally assess dozens or hundreds of small companies. It should still be noted that indexes and ETFs do not include all the small companies, so some hidden pearls might be missed, which an astute investor could unearth after a lot of work and due diligence.
1. iShares Russell 2000 ETF (IWM)
This large ETC replicates the performance of the Russell 2000 index.
The Russell 2000 is a subset of the Russell 3000 Index, which includes 98% of the investable U.S. stock market.
Because it covers 2,000 small caps at once, this ETF provides a very strong diversification with exposure to many sectors, US regions, business niches, etc, reflecting the broad spectrum of the US economy.
The top 5 sectors represented in this ETF are financial, industrial, healthcare, IT, and consumer goods (discretionary).
Source: iShares
2. Vanguard Small-Cap ETF (VB)
This highly diversified ETF, with 1356 stocks in its benchmark, the CRSP US Small Cap Index, offers a mix of growth and value investing styles.
Its largest segment is industrial companies (21.20%), followed by consumer goods (discretionary) (15.90%), and financials (15.10%).
Source: Vanguard
Overall, this diverse mix should reflect the overall health of the US economy, as well as potentially the effort of the Trump administration to relocate offshored industries back to the USA.
3. SPDR MSCI Europe Small Cap Value Weighted (ZPRX)
Not all small caps are located in the USA, and other countries and regions have a tendency to have more SMEs than large corporations, in large part due to smaller size or more fragmented markets. For example, most of the industrial capacity of Germany is built on the so-called “Mittelstand”, a network of highly specialized family-owned businesses.
The same is also true for many European agribusinesses, and even bank cooperatives, with, for example, in the top 3 holdings of this ETF, the Raiffeisen Bank International AG and the Banca Monte dei Paschi, which are both banks active in financing SMEs.
Source: SPDR
Investors can get access to such companies through this ETF, which specializes in European small caps. It follows the traditional market capitalization-weighted parent index, the MSCI Europe Small Cap Index. This includes up to 800-900 different stocks.
The top 4 countries represented are the UK (23.17%), Germany (11.95%), France (9.46%), and Sweden (7.37%).
By far, industrials are the most represented, making up 24.12% of the whole ETF, followed by consumer goods (discretionary), financials, and basic materials.
Source: SPDR
4. iShares MSCI World Small Cap UCITS ETF (WSML)
Small cap investors might want to build an even more geographically diversified portfolio of small caps, while not neglecting US companies either. For this, they can look in this ETF, which gives access to small caps all over the world.
This ETF is also relatively heavy on industrial companies, making up almost 20% of the whole fund, followed by financials, consumer goods (discretionary), IT, healthcare, and real estate.
Source: iShares
In terms of geography, the US is still by very far the largest segment, with 60% of the whole ETF, followed in order by Japan (12.64%), the UK (4.81%), Canada (3.76%), Australia (3.51%), and Sweden (2%).
Source: iShares
5. iShares MSCI AC Far East ex-Japan Small Cap UCITS ETF
Often, investors interested in small caps are trying to diversify risk from the largest companies, including leading US firms, or maybe even the US market as a whole.
From that perspective, a focus on Asia, the world’s most dynamic region in terms of economic growth, can make sense. And with a lot of growth, small caps are likely to be the prime beneficiaries of growing economies of scale, richer local consumers, improving infrastructures, and rising levels of education.
This ETF covers the Asian region, excluding Japan, as the country has more of the characteristics of a developed country and has been more stagnant since its last boom in the 1990s
The ETF has a strong exposure to Taiwan (33.07%), China (19.49%), South Korea (18.91%), and Singapore (8.05%), itself a financial center where many companies active in the ASEAN region are registered).
Source: iShares
From a sector point of view, the top 3 largest segments are IT (23.93%), industrial (16.54%), and real estate (11.07%).
Source: iShares
Conclusion
Investing in small caps is not for everyone, and it needs to be timed properly to outperform investment in stocks of larger companies. However, tools like small caps ETFs make it a lot simpler, as they provide access to hundreds or thousands of different companies at once despite small fees.
Selecting a small-cap ETF should be done depending on the position of this investment in a portfolio. If it is to provide more diversification to a US-centric portfolio, passive or active, it is likely best to pick a Russell 2000, Russell 3000, or another small cap ETF like Vanguard Small-Cap ETF. The exact pick will likely depend on the proportion of financial and industrial companies an investor prefers.
If the idea is to diversify risk further, incorporating other regions like European or Asian small cap ETFs can make a lot of sense, as it provides diversification from many angles at once: geographic, capitalization size, sectors, etc.
Lastly, a global approach can also be taken with a “world” small cap ETF. In this case, investors should pay attention to the actual composition of the ETF, as it might contain a lot more exposure to the USA and Western countries than the ETF’s title could let them think.