How to Profit From a Small Cap Index
Small cap stocks are well-known for outpacing some of the market’s larger blue chip companies. But not every investor can stomach the volatility and uncertainty that comes with small caps. Instead, they invest in a small cap index. Unfortunately, an index fund doesn’t necessarily have the same sky-high returns that a few well-chosen small caps will. So how can low-risk investors capitalize on small caps and profit from an index fund?
There are more ways to make money as an index investor than you might think – especially with a small cap. The promising returns of small caps can spur big gains in your portfolio. It all depends on how you use the index to your advantage.
What Is a Small Cap Index?
A small cap index tracks the performance of the smallest companies listed on major exchanges. Like all indexes, a small cap index is an aggregate average of the performance of these companies across all sectors. It’s a true representation of average returns from small cap companies. Some of the most reputable and trusted small cap indexes include…
- Russell 2000 Index
- Fidelity Small Cap Index Fund
- Northern Trust Small Cap Index
- Praxis Small Cap Index Fund
- Vanguard Small-Cap Index Fund.
Most of these indexes track the performance of the smallest 1000 or 2000 stocks; however, there are indexes that focus on smaller pools of 500 to 600 stocks. Regardless, they have the same goal: to benchmark the broad performance of small cap stocks.
When it comes to capitalizing on an index, there are several different ways investors can profit. Here’s a look at how to make the average work for your portfolio.
Invest in the Index Fund Itself
For passive or risk-averse investors, an index fund offers a unique appeal. Because it’s the aggregate average, there’s broad hedging against risk. This, of course, means your return on investment is always the average – nothing more, nothing less. And while many investors aren’t content with the market average, small caps offer the prospect of more.
Small caps traditionally outperform large caps in aggregate. That means an investment in small caps is actually market-beating. It may not seem like a huge return on investment, but a passive investment in a small cap index could put you ahead of other investors pegged to larger indexes. This is truly a great mix of low-risk and moderate-reward. The index mitigates volatility while still outpacing larger companies.
However, this isn’t always the case. It’s important to realize that large cap companies are still large caps for a reason – they generate massive gains. As an index investor, prepare to hold your passive investment for a longer time horizon to realize market-beating gains.
Find ETFs That Track the Index
If you’re open to slightly more risk, consider investing in a small cap exchange-traded fund (ETF) that’s pegged to a small cap index. These ETFs are often leveraged, which gives them more growth potential, as opposed to the pure index. Generalized small cap ETFs are the safest play. They’re not the only ones, however.
Small cap growth, value and emerging market funds all offer exposure to growth. While they might focus on sector-specific small cap investments, they’ll also track a large index – like the Russell 2000 Index or the Vanguard small cap index. This stability, coupled with sector-specific exposure, makes for a more lucrative investment. You’re not tied directly to a small cap index – rather, you’re investing in the periphery. This is especially true if you’re investing in a passive ETF.
Again, the key factor here is investing in a leveraged ETF. This will accelerate gains that track the performance of a greater index.
Use the Index as a Benchmark
One of the best ways to use an index to drive profitability is to use it as a benchmark. Instead of investing in an index or an ETF that tracks it, use it as a yardstick for your own collection of small caps.
For example, if you invest in a biotech small cap, you need to understand its performance relative to several benchmarks. First, track it against the healthcare industry as a whole. Then, compare it to a small cap index. If your biotech stock is up 5.6% over six months and the biotech sector is only up 2.8%, it’s outperforming the sector. However, if small caps are up 7.2% in that time, your biotech may actually be underperforming. While these numbers are relative, they’re important evaluators.
In this example, you don’t need to invest in an index to profit from it. Using it as a benchmark helps you make decisions about individual holdings that lead to better profitability – and more informed investing.
Small Caps Win Over Time
Small cap stocks outperform large and megacap companies – including indexes. Since 1972, small cap indexes have returned 15% annualized returns to investors, as opposed to the 13% from large cap indexes. Small caps tend to boom bigger and bust stronger. But, for the most part, they have a trend of outperforming the broader market. Investing in a small cap index is a great way to avoid the instability and reap the proven returns of small caps.
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Whether you choose to invest in an index fund, an index-tracking ETF or use the index as a benchmark for your own handpicked stocks, small caps are worth paying attention to.
Read next: “How to Invest in Small Cap Stocks”