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.

The Russell 2000 Index consists of approximately 2,000 of the smallest companies represented in the broader Russell 3000 Index. With a median market capitalization of $261 million, it contains more micro-cap stocks than the other indexes.

The S&P SmallCap 600 consists of 600 small-cap U.S. stocks with market capitalizations ranging from $20 million to $2.2 billion and a median market capitalization of $394 million. Unlike the other three indexes, which screen by market cap, this one also has an earnings screen that requires four quarters of profitability. That characteristic is probably what allowed the index to slightly outperform its competitors in 2008.

With a median market capitalization of $1 billion, the MSCI U.S. Small Cap 1750 Index contains the most midcap names of the group. The Dow Jones U.S. Small-Cap Total Stock Market Index, representing the small-cap portion of the Dow Jones U.S. Total Stock Market Index, has about 1,700 stocks and a median market capitalization of $538.15 million.

While returns for the four indexes are similar for the one- and three-year periods, the differences in their composition emerge in the long-term track records. During the five-year period ended June 17, the iShares Russell 2000 Index ETF saw an annualized drop of 5.66%, while the iShares S&P 600 ETF declined 2.8% and the Vanguard Small Cap ETF fell 1.25%.

There are also a number of smaller ETF contenders with interesting characteristics. The PowerShares FTSE RAFI U.S. 1500 Small-Mid Portfolio (PRFZ) is a fundamental weighted index that will be passing the three-year mark next month. The companies in the portfolio are 91% small cap and are selected and weighted based on four fundamental measures of size: book value, cash flow, sales and dividends. It is up 48% year to date as of June 17.

For the adventurous, Direxion offers its Daily Small Cap Bull 3X Shares (TNA), which seeks daily investment results of 300% of the price performance of the Russell 2000 Index. For those taking a dimmer view of the small-cap market, the Daily Small Cap Bear 3X Shares (TZA) inverts the formula, seeking the daily investment results of the same index but going 300% in the opposite direction of its price performance.

Studies Challenge Small-Cap Alpha
Conventional wisdom holds that while indexing works well for large caps, actively managed small-cap stock funds have a better chance of beating their benchmarks because managers are able to take advantage of market inefficiencies and uncover "hidden gems." For that reason, many financial advisors use ETFs for large-cap holdings but prefer actively managed mutual funds for small caps.
A number of studies, however, suggest that the ability of managers to beat their small-cap benchmarks is, at best, fleeting.
From 2004 to 2008, the S&P SmallCap 600 outperformed 85.5% of small-cap mutual funds, reports Standard & Poor's. That exceeded the outperformance of the large-cap S&P 500 Index, which outperformed 71.9% of actively managed large-cap funds over the same period. The results are similar to those of the previous five-year cycle from 1999 to 2003.
A study by Richard M. Ennis and Michael D. Sebastian of 128 institutional commingled funds and separate accounts showed that the median portfolio in the sample outperformed the small-cap Russell 2000 Index by 4.04% during the ten-year period ended June 30, 2001. However, after adjusting for management fees, benchmarking methodology and the eventual dissolution of some of the products, the authors concluded that the median alpha of the actively managed products is likely to be zero or negative.
According to a study by Vanguard economists, the outperformance of actively managed funds (with the Russell small cap used as benchmarks), was skewed upward by a minority of small-cap growth funds during the equity market bubble of the late 1990s. With a different set of small-cap benchmarks, the alpha of the median small-cap fund manager is zero before costs and negative after costs. "The historical probability of a small-cap active fund achieving positive alpha is equivalent to a coin toss before costs," the study concludes.