What is a Small Cap Stock Index?
For many investors, small cap stocks are too risky to undertake as individual investments. Instead, they turn to risk-mitigated approaches, such as a small cap stock index. These broad-focused representations of the small cap market are aggregated, diversified and risk-controlled. They also offer a more enticing investment opportunity for those who want small cap exposure without the burden of risk. They’re a favorite of passive investors.
But what, exactly, is a small cap stock index? As investors see the potential of small caps vs. the broader market, more and more are turning to indices as a way to tap into the earning power of the market’s burgeoning companies. Here’s what you need to know.
What is a Stock Index?
A stock index is an aggregation of securities that meet a specific set of criteria, such as cap size. Together, this broad smattering of companies creates a weighted average for that group. And it serves as a benchmark for the performance of other companies that meet the criteria. In this case, a small cap stock index would be the benchmark against which investors measure the performance of any single small cap company.
Buying into a stock index allows investors to invest in the relative average performance of the market based on the criteria of the index. Investors who want to bank on the gains of small caps without pigeonholing themselves to a few specific securities can invest in a small cap stock index and reap the rewards of a broad, diversified investment.
A Look at Major Small Cap Indices
Buying into an index fund is a form of passive investment. Index funds are widely regarded as the safest form of equity investment. This is because of their size. Moreover, aggregated securities diversify to the point of risk mitigation. Some of the common small cap indices tracked on United States stock markets include:
- Russell 2000 Index
- Russell 3000 Index
- S&P 400 Index
- S&P 600 Index
- Dow Jones U.S. Small-Cap Total Stock Market Index
There are also a ranging number of small cap stock index funds, which behave in roughly the same way as the indices themselves. Index funds mirror the composite makeup of the index, using a different base value to calculate the fund’s composition.
Index funds make it possible for individuals to buy into the index’s performance without spending the significant sum that comes from buying into the index directly. For example, the cost of one share of the Russell 2000 Index (RUT) is roughly $2,300 (November 2021). Conversely, shares of the Vanguard Russell 2000 ETF (VTWO) trade for roughly $93.50. The ETF tracks the index, to mimic its returns.
Domestic vs. International Index?
As they explore the world of small cap stock index investing, investors have the potential to look beyond their own borders. Small caps are extremely popular around the world and are commonly the focus of emerging market funds. While there are several big-name domestic small cap indices, there are also international small cap indices to consider.
For example, the MSCI World Small Cap Index and S&P Global SmallCap indexes both track global small cap companies. And, similarly, the iShares MSCI World Small Cap UCITS ETF (WSML) and the iShares International Select Dividend ETF (IDV) are both index funds that track them, respectively.
When considering international small cap index investing, pay attention to the number of countries included in the index, as well as whether it’s cap- or price-weighted. Remember that the broader the index and the more aggregate securities, the lower the risk, volatility and reward.
The Risks of Investing in a Small Cap Index
By and large, small cap stock index investing is about as safe as you can get when investing in equities. The broad nature of the index is an effective hedge against price volatility and movement among small caps. It also protects against general market skews that can affect particular sectors. Indices are truly the great balancing vehicles in stock investing.
Small cap stock index investments aren’t without risk. Like any equity position, the index will see price fluctuations at any given time. These indexes are also prone to rebalancing as small cap companies fall out. For example, when compared to the bottom 10% of large cap companies, it’s much more likely that 20 companies from the bottom 10% of the stock market will merge, declare bankruptcy, be acquired or grow out of the small cap index. While this rebalancing doesn’t tend to affect indices all that much, indexed funds might see more price turbulence as a result.
Index Funds Offer Broad Exposure
For investors who like the appeal of small cap stocks and want to capitalize on their potential upside, an aggregate approach tends to be a safe bet. And, for passive investors who don’t want to spend the time monitoring these sometimes-volatile investments, index investing is the way to go.
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While a small cap stock index won’t offer the boom-or-bust prospects of any single up-and-coming small cap performer, it does offer a regression to the mean that’s much easier to track. And when you consider that the meaning of a small cap index is still representative of growth-focused startups, it’s difficult to ignore the potential of a small cap index investment.
For those who want access to a small cap stock index without an exorbitant price per share, there’s also index funds. Both represent the broad potential of small cap stocks, while taking into account the inherent risk that comes with them.