Small-cap stocks have historically outperformed large-cap stocks over long-term horizons. However, this excess return can be extremely volatile. During economic expansions, small-cap stocks tend to show superior returns. During economic recessions, they decline at a much faster rate compared to their large-cap counterparts. Small caps show greater sensitivity to macroeconomic risks.
Companies with small-cap stocks typically lack competitive advantages and efficient scales to withstand bad times. This is why these companies are less profitable and generate smaller returns compared to large-cap stocks. As small-cap companies are more likely to show greater growth rates, they also enjoy high investor sentiment and lofty valuations, which can quickly reverse when sentiment wanes.
Despite wide small-cap stocks' underperformance in 2015 compared to a broad market, holding small-cap equities can be beneficial for diversification and long-term capital appreciation. The mutual funds industry offers some excellent choices for investors at a reasonable cost.
Small-cap stocks may continue showing heightened volatility levels in 2016 due to greater perceived risks. However, small-cap core mutual funds offer attractive options for investors interested in diversifying their portfolio with a specific niche of the U.S. equities market.
Vanguard Small Capitalization Index Fund Investor Shares
Assets under management (AUM): $56 billion
2010-2015 average annual net asset value (NAV) return: 12.9%
Net expense ratio: 0.23%
The Vanguard Small Capitalization Index Fund Investor Shares tracks the performance of the CRSP U.S. Small Cap Index, which is composed of small-cap stocks of U.S. companies. The fund offers passive exposure to small-cap stocks with broad diversification across different sectors of the U.S. economy. Financial stocks account for about 26% of the fund's assets, while industrial equities have about 20% allocation. Compared to other funds, this fund has a very low turnover ratio of 10%, which makes it highly tax-efficient. The holdings are broadly diversified, with no single stock accounting for more than 0.5% of the fund's portfolio.
The fund has earned the Morningstar analyst rating of gold and a four-star overall rating for its consistent risk-adjusted returns and extremely low cost. The fund comes with no load fees and has a $3,000 minimum investment requirement.
Homestead Small Company Stock Fund
AUM: $1.2 billion
2010-2015 average annual NAV return: 14.26%
Net expense ratio: 0.91%
The Homestead Small Company Stock Fund invests in small-cap stocks on the Russell 2000 Index. The fund specifically focuses on companies that are positioned to make significant changes in their business that may result in an improved competitive position or financial results. Compared to the Russell 2000 Index, this mutual fund has a much larger asset allocation to industrial companies at about 27%. Consumer discretionary stocks and financial stocks account for 22% and 18% of the fund's portfolio, respectively. The fund typically buys and holds stocks for a long time, resulting in an exceptionally low turnover ratio of 3%. This buy-and-hold strategy makes the fund highly tax-efficient.
The fund has consistently beaten its benchmark index over the last three, five and 10 years. For its strong risk-adjusted returns, the fund has earned a five-star overall rating from Morningstar. The fund comes with no load fees and requires an initial contribution of $500.
Broadview Opportunity Fund
AUM: $708.3 million
2010-2015 average annual NAV return: 11.21%
Net expense ratio: 1.23%
The Broadview Opportunity Fund seeks capital appreciation by holding small-cap stocks over a two- or three-year horizon. The fund assesses a combination of attractive valuation and qualitative features for a prospective company that can be added to the portfolio. Because the fund can promptly divest stocks that violate its fundamental principles, its turnover ratio can be somewhat high; in 2015, it stood at 41%. This made this mutual fund somewhat less tax-efficient. The fund has an overweight position in consumer cyclical stocks with about 27% allocation, while information technology accounts for 24% of the fund's assets. No single holding of the fund has an allocation exceeding 4%.
Morningstar has awarded this fund an analysts' rating of silver and a four-star overall rating. The fund charges no load fees and comes with a $1,000 minimum investment requirement.
Glenmede Small Cap Equity Portfolio Class Advisor
AUM: $2.3 billion
2010-2015 average annual NAV return: 14.44%
Net expense ratio: 0.94%
The Glenmede Small Cap Equity Portfolio Class Advisor invests in small-cap stocks with attractive combinations of valuation and positive earnings and sales momentum. The fund bases its holdings selection on proprietary multifactor models that rank stocks within each sector. Fund managers structure the portfolio to provide a broad diversification across sectors, industries and individual firms, with the Russell 2000 being a benchmark index. Consumer cyclical stocks have the highest allocation of about 18%, while information technology accounts for about 17% of the fund's assets. The fund's holdings are typically widely dispersed and do not account for more than 2% of its portfolio.
The fund was able to outperform its underlying index over the last three, five and 10 years and has earned a five-star overall rating from Morningstar. It comes with no load fees and no minimum investment requirement.
Voya Small Company Fund Class A
AUM: $468.7 million
2010-2015 average annual NAV return: 12.17%
Net expense ratio: 1.34%
The Voya Small Company Fund Class A invests in small-cap stocks of companies. Fund managers select holdings based on internally developed quantitative computer models that evaluate the company's financial and fundamental characteristics. The fund focuses on stocks that trade below the value perceived by the consensus view. Compared to its peers, the fund is more broadly diversified in terms of sectors, with financial stocks having the largest allocation at about 18%. Industrial equities account for 17% of the fund's assets, while information technology stocks have 16% allocation. The fund's holdings are fairly diversified, and no single stock accounts for over 1.5% of the fund's portfolio.
On average, the fund has slightly outperformed the Russell 2000 Index. As of November 2015, the fund's one-year average annual return of 7.95% slightly exceeds the average annual return of 7.31% for the Russell 2000 Index. This mutual fund has earned a four-star overall rating from Morningstar. The fund comes with a load fee of 5.75% and requires a $1,000 minimum investment.