Investing in a small-cap value fund is a simple way to diversify your portfolio. These funds offer exposure to companies with a smaller market capitalization and an investment focus on value instead of growth. Small-cap value funds can come in a few different forms, such as traditional mutual funds, index funds or even ETFs. But although the small-cap stocks of early-stage companies have the potential to provide prosperous growth, they can often be equally volatile.
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What Is a Small-Cap Value Fund?
To understand what these funds are and what they invest in, it helps to first break down what small-cap and value mean.
Cap refers to market capitalization or the total dollar market value of a company’s outstanding shares of stock. Companies can be identified as large-cap, mid-cap or small-cap, based on the value of its shares. Generally, a company that’s small-cap is one with a market capitalization ranging from $300 million to $2 billion. By comparison, a large-cap stock would have a market capitalization of more than $10 billion.
Value is a specific investing strategy. Value investors choose stocks based on their intrinsic value. The basic premise is that by looking for stocks that are undervalued and holding them for the long term, you could realize significant gains. Value stocks are typically established companies and they may or may not pay dividends to their investors.
A small-cap value fund combines the two categories. The fund invests in value stocks that fit the small-cap label. Ideally, this results in better returns since historically, small-caps and value stocks have outperformed their mid-cap, large-cap and growth stock competitors, respectively.
Types of Small-Cap Value Funds
Small-cap value funds can take different approaches with their investment strategy. There are three main categories of funds you can choose from: traditional mutual funds, index funds and ETFs.
Mutual funds combine a collection of different assets into a single fund. Investors pool their money together to own shares in the fund and profit from gains. Small-cap value mutual funds can focus on capital appreciation, income or both. The MFS New Discovery Value Fund (NDVAX), for example, is a small-cap value fund that’s designed for capital appreciation first and dividend income second.
Index funds follow a passive investment strategy, in that they attempt to match the performance of a benchmark index. Vanguard’s Small-Cap Value Index Fund (VISVX) is an example of a small-cap value index fund. This fund uses the Spliced Small Cap Value Index as its benchmark and invests in more than 850 small-cap domestic value companies along with a smaller share of U.S. Treasuries.
Exchange-Traded Funds (ETFs)
Exchange-traded funds or ETFs are mutual funds that trade on an exchange like a stock. ETFs can abide by either active or passive management. This potentially offers extra tax efficiency and lower costs than index or traditional mutual funds. Vanguard’s Small-Cap Value ETF (VBR), for instance, has an expense ratio of just 0.07% as of April 2020.
Pros and Cons of Small-Cap Value Funds
Like any other investment, small-cap value funds have their advantages and disadvantages. Weighing both against one another can help you decide whether these funds are a good choice for your overall investment strategy. Note that regardless of whether you invest in a small-cap value fund or not, your portfolio should include multiple types of securities so your assets are diversified.
All investment types come with their own inherent risks, and small-cap value funds are no different. Because these funds focus on companies in the earlier stages of their life cycles, they are generally riskier. Below, you’ll find a couple of points to watch out for when investing in small-cap value funds.
How to Invest in Small-Cap Value Funds
You can purchase shares of small-cap value mutual funds, index funds and ETFs through an online brokerage. If you’re saving for retirement, you can also invest in them through a tax-advantaged retirement account. When choosing which funds to invest in, the most important considerations include:
If you’re investing in more than one small-cap value fund or ETF, make sure you’re comparing the underlying investments carefully. You may assume that purchasing two different funds means you’re getting exposure to a different mix of investments but if they both track a similar index then it’s possible you could be over-weighted in one or more areas. Instead of reducing risk, you might increase it without realizing it.
Investing in small-cap value funds could pay off if the underlying stocks in those funds match or exceed growth expectations. But small-cap investing can be riskier and require more patience than investing in mid- or large-cap stocks. In the end, though, these funds can help you to create a more well-rounded portfolio over time.
As we’ve stated a few times, it’s important to spread your investable assets throughout more than just small-cap value funds. However, this is true of any investment. Diversifying your assets can protect you from being overly reliant on a very specific area of the market.
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