Stock Strategist: Why and How to Index in U.S. Small Caps

[Morningstar Logo]( [Company Site]( [Company News]( [Membership]( [Portfolio]( [Stocks]( [Options]( [Funds]( [ETFs]( [Markets]( [Tools]( [Personal Finance]( [Discuss]( Stock Strategist Why and How to Index in U.S. Small Caps Broad diversification and low fees make indexing a good bet in this arena. [tab_bar] by Venkata Sai Uppaluri | 4/15/2020 2:30:00 PM Small caps make up a tiny minority of the total market capitalization of the U.S. stock market. Depending on the index family in question, they account for anywhere from 3% to 12% of the total value of U.S. stocks. Accordingly, they tend to play a bit part in most investors’ portfolios. In this article, I will look at the case for indexing within U.S. small caps and highlight some of our top-rated funds offering indexed exposure to this segment of the market. The Case for Indexing U.S. Small CapsSmall caps are an area of the market where active managers have generally been more successful--certainly relative to their large-cap counterparts. According to Morningstar’s year-end 2019 U.S. Active/Passive Barometer, 35.5% of actively managed U.S. small-blend funds outperformed their average passive peer over the 20 years through December 2019. Just 14.3% of actively managed U.S. large-blend funds that were around two decades ago managed to survive and outperform their average passive peer over this same span. While small-cap managers fared better than stock-pickers operating in the land of large caps, a 35.5% long-term success rate isn’t exactly something to write home about. There’s a strong case to be made for indexing in the U.S. small-cap space. What explains passive funds’ impressive track record in the small-cap segment? There are several factors at play. Even as you go down the market-cap spectrum, markets tend to be efficient, especially over the long term. No different than large caps, it is difficult for investors to gain and maintain an informational advantage in the small-cap space, especially as the cost of acquiring and processing publicly available information has never been lower. Stock prices tend to incorporate this information quickly, making it difficult to capitalize on mispricings when they do arise. Index funds piggyback on the valuation work done by their active peers. They absorb market participants’ collective opinions of the value of the stocks they own. And they have a significant cost advantage over their active peers, given that they’re free-riding on all their hard work. Together, these factors explain why market-cap-weighted index funds have been tough competition for active managers over the long term--with the U.S. small-cap space being no exception. How Small is Small?There are several indexes that are used as barometers of small-cap stocks. But not all small-cap indexes are created equal. There are some important differences between them which are rooted in the specifics of their methodologies. To read more, click [here](. Sponsored Links [Buy a Link Now]( Podcast: Investing Insights From Morningstar.com Listen to a roundup of the latest videos featured on Morningstar.com [in this podcast]( available through iTunes. Free Issue | Morningstar's Stock Newsletter >> Morningstar StockInvestor is celebrating more than 10 successful years of high-quality stock investing. Its two real-money portfolios have outperformed the S&P 500 since 2001. [Get new ideas for the core of your stock portfolio](. Search Most Recent Articles [What's Behind These Funds' Sharp Star-Rating Declines?]( [Have Small Value Stocks Become a Bargain?]( [Baby Steps for Reducing Risk]( Latest Analyst Reports [Invesco Equally-Wtd S&P 500 A]( [Natixis Vaughan Nelson Value Opp A]( [Eaton Vance Income Fund of Boston I]( [Oakmark Global Select Investor]( [Victory Floating Rate Y]( ABOUT OUR EMAIL TO UNSUBSCRIBE this email address to the Stock Strategist newsletter, please click "reply" and then click "send." This will unsubscribe only this email address to this specific newsletter. All subscription changes will take effect within one business day. Replies are not read by individuals, so please do not use this for queries about Morningstar.com. If you have questions about Morningstar.com or your membership, send a note to [joe@morningstar.com](mailto:%20joe@morningstar.com). ABOUT OUR PRIVACY POLICY Please [click here]( to learn about Morningstar's privacy policy. (c) Copyright 2020. Morningstar, Inc. 22 West Washington Chicago, Illinois, 60602 All rights reserved.