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Investing in a small-cap value fund is one way to diversify a 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 be traditional mutual funds, index funds or even exchange-traded funds. This guide offers an overview of how these funds work, what their performance is like compared to other fund types and what you need to know to invest.

Small-Cap Value Fund Defined

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.

1. Mutual Funds

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.

2. Index Funds

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.

3. Exchange-Traded Funds

Exchange-traded funds or ETFs are mutual funds that trade on an exchange like a stock. ETFs can be actively or passively managed, potentially offering increased 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 0.06%.

Pros of Small-Cap Value Fund Investing

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.

  • Growth Potential. By nature, small-cap companies are better positioned to grow compared to mid- or large-caps that are already generating tens or even hundreds of billions in revenue each year. Investors who buy in before a security has begun to grow can benefit as the company expands and share prices increase.
  • Less Competition. Small-cap value funds can be appealing to the everyday investor if there’s less competition from larger institutional investors. This can help keep prices from skyrocketing and putting shares of a particular fund out of reach.
  • Performance. Small-cap value funds have the potential to deliver solid returns to investors if the stocks in the fund benefit from growth and price appreciation over time. The average small value fund returns approximately 9% on a 10-year basis, which closely aligns with the average historical return of 10% associated with the S&P 500.
  • Adaptability. In addition to growth and performance, small-cap value funds may hold their value better during periods of stock market volatility. Large-cap stocks ($10 billion and up) and even mid-cap stocks ($2 billion to $10 billion) may be more susceptible to shedding value during periods of price fluctuations or a correction that precedes a recession.
  • Cost. One of the most important costs to pay attention to when investing in any mutual fund, index fund or ETF is the expense ratio. This number determines what you pay to own the fund each year and what percentage of returns you get to keep. Many small-cap value funds and ETFs can offer lower expense ratios compared to other fund options.

Cons of Small-Cap Value Fund Investing

  • Volatility. Small-cap stocks can be associated with established companies as well as newer companies that are still building their foundation. Small-caps that are in the early stages may experience more volatility if they’re still refining their business model or defining their niche in the marketplace. For that reason, small-cap stocks tend to carry a higher degree of risk for investors versus their mid-cap and large-cap counterparts.
  • Patience is required. Investing in small-cap value funds is something of a waiting game for investors since it can take time for companies to grow and the broader investment community to recognize its value. If you’re looking for short-term income or a quick win from an investment, these funds may not suit your needs.

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 or in a tax-advantaged retirement account. When choosing which funds to invest in, the most important considerations include:

  • Fund size
  • Investment mix and number of holdings
  • Expense ratio and other fund costs
  • How often investments in the fund turn over
  • Fund objective (i.e. capital appreciation or dividend income)
  • Sector exposure

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 overweighted in one or more areas. Instead of reducing risk, you might increase it without realizing it.

Bottom Line

Investing in small-cap value funds could pay off if the underlying stocks in those funds match or exceed growth expectations. While small-cap investing can be riskier and require more patience in some ways than investing in mid- or large-caps, these funds can help you to create a more well-rounded portfolio over time.

Tips

  • Consider talking to a financial advisor about the merits of small-cap value funds in more detail. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • When deciding between small-cap value funds and ETFs, keep tax efficiency in mind. Many ETFs tend to have a lower turnover ratio, meaning assets are bought and sold inside the fund less frequently. Lower turnover means fewer taxable events for you if fund assets are sold at a profit. If you’re investing in small-cap value ETFs, they may be better suited to a taxable investment account while funds that have a higher turnover ratio may work better in a 401(k) or IRA. These accounts defer taxes on gains until you begin taking qualified withdrawals at age 59 1/2 or beyond.

Photo credit: ©iStock.com/MicroStockHub, @iStock.com/LeoPatrizi, ©iStock.com/Tinnakorn Jorruang

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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