Small-Cap ETFs Poised for Big Growth as Rate Outlook Shifts

Key Points

• Avantis U.S. Small Cap Value gives investors active exposure to profitable, lower-valuation small-cap stocks.
• Vanguard Small-Cap offers broad, low-cost access to small-cap companies across value and growth categories.
• iShares Russell 2000 remains one of the most liquid ways to track the broader U.S. small-cap market.

The small-cap equities world carries a number of risks—unproven companies, higher volatility, and so on—but also brings the opportunity for growth that may outpace some larger names. International small-cap names may be heating up, and while small-cap stocks in the United States have already had a good run, many valuations remain comparably attractive when held up against mega-cap tech stocks and other top names. A big factor is the interest rate environment: investors predicting that the Fed might hold rates steady or even lower them at some point in the foreseeable future might want to stock up on small-cap names to buy and hold before that time.

One of the easiest and best ways to do so is through dedicated small-cap stock exchange-traded funds (ETFs). Fortunately, there are many different options, each providing a slightly different strategy to build diversification into the small-cap space, whether you're looking for a modest allocation or a more significant lean-in.

A Modestly Priced Active Fund With a Value Twist

The Avantis U.S. Small Cap Value ETF NYSEARCA: AVUV holds a basket of small-cap companies based in the United States that have low valuations and higher profitability ratios compared to the broader Russell 2000 Index. While the fund is thus related to this index, it is in fact an actively managed ETF, allowing the fund managers to make agile adjustments to the portfolio based on new information and without having to wait for rebalancing.

AVUV's portfolio is large, and the fund holds close to 800 different stocks. AVUV’s portfolio is broad, with close to 800 holdings. The fund is also fairly evenly weighted, although its top 50 positions account for just over 30% of assets. The result of the unique approach that AVUV takes is a strong, market-beating performance so far this year: AVUV has returned nearly 22% year to date (YTD). Given its active structure, investors may be surprised to see that its expense ratio is still not all that high at 0.25% (although there are cheaper alternatives for those prioritizing low annual fees). AVUV also has a healthy asset base of about $29 billion and strong trading volume.

One of the Lowest-Cost Options Still Outperforms

Speaking of lower-cost funds, the Vanguard Small Cap ETF NYSEARCA: VB fits the bill perfectly. This is one of the cheapest means of accessing the small-cap space, as the fund has an annual fee of just 0.03%. VB is a passively managed fund linked to a broad index of small-cap stocks, so it carries names with both value and growth characteristics.

VB's wide-ranging portfolio has more than 1,300 positions, and the top 50 of those represent a smaller 18.5% of AUM compared to AVUV. No single stock in the basket accounts for more than 0.7% of the portfolio—this may be attractive to investors interested in the small-cap universe but seeking ways to mitigate the risk profile of individual stocks via broad diversification.

Given its approach, investors might expect VB to attract buy-and-hold investors, and the data seems to suggest this: the fund has more than $81 billion in AUM but only half the average trading volume of AVUV. Of course, with YTD returns above 16%, this inexpensive fund may not give investors too many reasons to consider selling anyway.

Broadest Access to the Russell 2000

Far and away the most popular fund on this list, based on trading volume, is the iShares Russell 2000 ETF NYSEARCA: IWM. This fund has a one-month average trading volume of more than 29 million shares, many times higher than AVUV above, on a solid $82 billion in AUM. As the fund's name suggests, it provides broad exposure to the Russell 2000 Index, so investors can expect a portfolio of roughly 2,000 names with extremely generous diversification.

Because of the size of IWM's portfolio, it is in some ways the best all-around stand-in ETF for the small-cap space as a whole. Thanks to strong momentum already in the year, the fund has returned more than 21% YTD. What investors may want to keep in mind when considering a small-cap fund is that IWM is not the cheapest ETF in this corner of the market. Its expense ratio of 0.19% lies between the fees of the two funds above. Cheaper alternatives in the small-cap universe do exist, although it can be tough to find exposure to just as long a list of U.S. stocks as IWM provides. Still, the annual fee for this fund is not especially high overall compared with many ETFs on the market.