History shows that small company stocks are often among the first victims of a souring economy, and also among the first beneficiaries of an economic recovery. They beat large caps in the years following the Great Depression, and they did so again for the ten years following the deep recession in the early 1970s.

After getting slammed in 2008, small company stocks-typically defined as those with a market capitalization of between $300 million and $2 billion-came roaring back in the spring as investors saw green shoots of hope peek through the economic dirt. For the 13 weeks ended June 17, the iShares Russell 2000 Index (IWM), an exchange-traded fund based on the small-cap Russell 2000 Index, was up 30%, compared with 22% for the large-cap SPDR S&P 500 (SPY). It was the third most heavily traded ETF in May, falling just behind the SPDR S&P 500 and the PowerShares QQQ Trust.

Small caps have a number of characteristics that appeal to investors. The companies they represent are often less weighed down by debt than many larger firms and can react to change more quickly than their more bureaucratic peers. And because they tend to operate mainly in the U.S., they don't have as much exposure to fluctuations in overseas demand and currency risk.

Some advisors are looking to small-cap stocks to lead the way toward a prolonged market recovery. "Data from recessions dating back to 1931 suggests that small caps will probably outperform large caps as we emerge from the recession and the market bounces back," says Tom Lydon of Etftrends.com.

Others are less optimistic. "One reason the rally in small caps has been so strong is because the hole they had to climb out of was so big," says Stephen Wood, senior portfolio strategist at Russell Investments. A slower-than-expected economic recovery could derail their upturn and drive investors toward larger, more established companies, he points out. And so far this year, the performance difference between the large-cap Russell 1000 Index and the small-cap Russell 2000 Index is razor thin. Still, he believes "a consistent representation of small caps in many portfolios is appropriate."

Mining The Market
The number of small-cap investment options has increased with the introduction of exchange-traded funds that focus on this segment. Like mutual funds, the ETFs represent ownership in a diversified portfolio of stocks. But their expense ratios typically range from 0.10% to 0.20%, while the average equity fund expense is 1.5%. The ETFs won't drift into midcap territory as many small-cap mutual funds do when their holdings increase substantially in value. While some actively managed small-cap mutual funds run up against liquidity and management issues as they get bigger, that isn't as much of a problem with the ETFs, which are based on passive indexes.

One thing the ETFs don't offer is savvy managers who can take advantage of inefficiencies and buying opportunities. However, even though many believe that the small-cap corner of the market benefits from the guiding hand of active managers, some studies, including those discussed in the accompanying sidebar, question the value of active management.

"A lot of advisors subscribe to the idea of using indexing for large-cap core holdings and actively managed mutual funds for the satellite portion of portfolios," says Michael McClary, vice president at ValMark Advisors in Akron, Ohio, which specializes in managing ETF portfolios. "But frankly, the evidence shows that the perceived advantage of active management in small-cap funds is a myth." He adds that with their high turnover, small-cap mutual funds are also more expensive and less tax efficient than the ETFs. Currently, his firm's model portfolios allocate between 7% and 19% of assets to small companies.

There are now 28 small-cap ETFs available to investors, according to indexuniverse.com, and the market is dominated by a few heavily traded ones. Barclays covers the Russell 2000 Index with the iShares Russell 2000 Index ETF. The firm also has a small-cap ETF based on the S&P 600 Small Cap Index, the iShares S&P 600 (IJR). Vanguard's Small Cap ETF (VB) is based on the MSCI Index 1750 Index, while the SPDR Dow Jones Small Cap ETF (DSC) takes its cue from the Dow Jones U.S. Small-Cap Total Stock Market Index.

All four of the ETFs have siblings based on their growth and value components, and all have ridden the small-cap rally since March. However, there are some important differences between the indexes they follow.