A:

The best small-cap index funds are the iShares Russell 2000 ETF (IWM), SPDR S&P 600 Small Cap ETF (SLY), Vanguard Russell 2000 ETF (VTWO) and Vanguard Small Cap Index Fund (VB). These funds are rated highly by U.S. News & World Report in terms of liquidity, costs and diversification. These are all exchange-traded funds (ETFs). IWM is the most tracked and traded.

Many investors prefer watching small-cap funds to more mainstream market indexes such as the S&P 500 or Dow Jones Industrial Average (DJIA), feeling they are a better representation of the economy and overall stock market. This is because small-cap companies are more sensitive to economic growth and are domestically focused.

Small caps are unique in that they are highly leveraged to the economy. These companies have smaller balance sheets and are more exposed to the economic cycle. During recessions, many may go bankrupt. This is in contrast to mid-cap and large-cap companies that have more established operations and reserves to get through and thrive during turbulent times.

For these reasons, small caps are considered a leading indicator for the economy. When traders become enthused about prospects for economic growth, they move into small caps. When they are worried about a slowdown, they start to sell small caps first.

Large-cap companies tend to do business all over the world. More than half of the revenues of the firms in the S&P 500 come from abroad. In contrast, more than 90% of the revenues of small caps comes in domestically. Therefore, periods of relative outperformance by small caps over large caps is meaningful in implying domestic economic strength.

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