Small-cap stocks and exchange-traded funds (ETFs) tend to have more growth potential than their large-cap counterparts, although there's also more room for volatility. That being said, economic conditions in the first half of 2019 imply the possibility of a solid performance for small caps.

Key Takeaways

  • Small-cap stocks tend to have more growth potential than their large-cap counterparts.
  • This growth, however, comes with greater risk and volatility.
  • Investing in small-cap stocks is made easier using ETFs that capture a wide swath of the market segment.

Growth conditions for small caps were beginning to take shape before the election of Donald Trump, but the new administration has contributed to the improved landscape for this investment class. The possibility of a more favorable regulatory framework in the financial industry, for example, suggests that smaller companies will have access to the capital they need to grow. 

Meanwhile, the market views tax reform and a reduction in corporate taxes as a potential catalyst for smaller stocks. Tax reform could be particularly beneficial to this asset class because smaller companies depend on domestic sales for the majority of their revenue, whereas large multinational companies derive significant revenues overseas. A study by Goldman Sachs highlighted small caps as one of the categories of stocks that would benefit the most from the enactment of tax reform.

Funds in this article were chosen on the basis of performance and assets under management. Year-to-date (YTD) performance figures reflect the period of Jan. 1, 2018, through May 4, 2019. Figures are current as of May 4, 2019.

1. The iShares Russell 2000 Growth ETF (IWO)

  • Issuer: BlackRock, Inc. (BLK)
  • Average volume: 1.3 million shares
  • Net assets: $9.3 billion
  • Yield: 0.62%
  • YTD return: 20%
  • Expense ratio (net): 0.24%

This small-cap fund tracks the popular Russell 2000 Index, which selects the U.S. stocks that rank between 1,001 and 3,000 in terms of market capitalization. There are currently 1,166 holdings in IWO's portfolio. The ETF does a great job of matching its index and even outperforms it on occasion. Spreads are very tight, and liquidity is excellent compared with other funds tracking this index.

IWO's top three sectors – technology, healthcare, and industrials – account for over 60% of its holdings. You'll also find a few micro-caps in the mix, which skews the ETF's average market cap downward relative to other funds in this category. One-, three- and five-year annualized returns are 30.51%, 16.45% and 14.34%, respectively. 

2. The iShares Core S&P Small-Cap ETF (IJR)

  • Issuer: BlackRock
  • Average volume: 3.3 million shares
  • Net assets: $45 billion
  • Yield: 1.37%
  • YTD return: 14%
  • Expense ratio (net): 0.07%

This well-established fund is one of the largest and most popular in the small-cap space. It tracks the S&P Small Cap 600, which represents about 3% of the U.S. securities market. Extremely tight spreads and deep liquidity (3,383,806 shares in average daily volume) make this fund attractive for every type of investor, and its holding costs are low compared with the Vanguard Small-Cap 600 ETF (VIOO) and the SPDR S&P 600 Small Cap ETF (SLY), which track the same index.

IJR's top three sectors are financial, industrial and technology, together accounting for over 50% of the fund's portfolio. One-, three- and five-year annualized returns are 32.40%, 19.27% and 15.39%, respectively.

3. The Vanguard Small-Cap ETF (VB)

  • Issuer: Vanguard
  • Average volume: 1.2 million shares
  • Net assets: $97.63 billion
  • Yield: 1.19%
  • YTD return: 20%
  • Expense ratio (net): 0.05%

This fund tracks the CRSP U.S. Small Cap Index, which picks from roughly the bottom 2% to 15% of available publicly traded stocks. With average daily volumes approaching $100 million, low holding costs and tight spreads, VB offers solid exposure to the small-cap market for every class of investor.

The fund is tilted toward industrials and technology, each of which accounts for approximately 16% of the ETF's holdings. One-, three- and five-year annualized returns are 23.71%, 15.15% and 13.08%, respectively.