This Could Be The BEST Way To Own Small-Cap Stocks

If you're more of a risk-taker, then you've probably noticed how well the stocks of small companies, or "small-cap" stocks, have been doing. During the three-year period ended March 27, 2012, the Russell 2000 Index of U.S. small-cap stocks returned an average of 26.7% a year.

This rate of return was more than four percentage points better than the S&P 500's 22.6% during the same period.This is just the latest example of why investors should consider including a healthy portion of small-caps -- stocks with market capitalizations of less than $1 billion -- in their portfolios.

While these stocks can be more volatile than the shares of mid- and large-cap companies in the short-term, for those who buy and hold, there's a real chance of major long-term outperformance, since smaller companies often have greater prospects for high growth.
 
But rather than focusing on stock-picking with these companies, investors seeking broad exposure to fast-growing small-caps should consider the Vanguard Small Cap Index Fund (Nasdaq: NAESX). Even though the fund's performance mirrors that of an index, the fund has significantly outperformed the small blend category -- and S&P 500 -- not only during the past few years, but for much longer time spans, as the table below illustrates. (A "blend" fund, if you're unfamiliar with the term, is simply a fund that holds a mix of growth and value stocks.)

The fund's 10-year record in particular demonstrates staying power. Although an 8.1% rate of return may not seem remarkable in absolute terms, it's a notch above the category average of 7.1% and far superior to the S&P 500's 4.2% rate of return during the same 10-year period. A category ranking of 30 for the prior 10 years means the fund placed in the top 30% of the small-blend category. In other words, it beat 70% of its peers for an entire decade.
 
The main reason for this dominance and why I think it will continue: In May 2003, the fund switched indexes and now tracks the MSCI U.S. Small Cap 1750 instead of the Russell 2000. This new index allows for more flexibility, so if a small cap stock loses or gains market value and technically isn't a small cap anymore, it can remain in the index for a time. This allows the Vanguard Small Cap Index fund to hold more micro-cap stocks and mid-cap stocks, which can boost returns when either or both outperform small-caps. (Mid-caps are stocks with a market capitalization of $1 billion to $10 billion. And while the definition of micro-cap varies, many investors consider a stock a micro-cap if the market capitalization is $250 million or less.) The MSCI U.S. Small Cap 1750 is currently about 60% small-cap stocks, 22% mid-caps and 18% micro-caps. The top five holdings are Panera Bread Co., Inc (Nasdaq: PNRA), Corn Products International, Inc. (NYSE: CPO), Oil States International, Inc. (NYSE: OIS), ITC Holdings Corp. (NYSE: ITC) and Biomarin Pharmaceutical, Inc. (Nasdaq: BMRN).
 
Because the index doesn't immediately have to jettison stocks that no longer meet the definition of small-cap, funds that track it trade a lot less than they'd have to in order to mimic the Russell 2000. Indeed, Vanguard Small Cap Index Fund's turnover ratio (the percentage of holdings replaced each year) has ranged from 12% to 24% since the fund started tracking the MSCI U.S. Small Cap 1750. When it was mirroring the Russell 2000, turnover was in the 35% to 40% range.
 
Lower turnover is always desirable, because trading less means better after-tax rates of return, since any profits from securities sales are passed on to shareholders as taxable gains. Moreover, the expense ratio (annual management fees and other operational costs as a percentage of fund assets) is a mere 0.24%. This is dirt cheap compared with the category average of 1.37%.
 
Risks to Consider: The MSCI U.S. Small Cap 1750 is clearly a better index than the Russell 2000. But it's still all about smaller stocks, which can be highly volatile. The Vanguard Small Cap Index Fund tracks the index precisely, so anything the index does, the fund will do.
 
If you're looking for a top-notch small-cap mutual fund, then consider the Vanguard Small Cap Index Fund. Few peers have outperformed it in the short- or long-term, it's highly tax-efficient and it's very inexpensive to own. Because the fund holds so many stocks -- usually about 1,750 -- just like the index -- it provides excellent diversification, too.

byTim Begany