A dozen domestic small-cap funds earn Morningstar Fund Analyst Ratings of Gold.
Investors gravitate to small companies for many reasons. Some want to participate in what has been called the "small-cap effect," or the theory that smaller companies have greater growth opportunities than larger companies and, as a result, have greater total return potential over time.
Others want a small dose of small companies in their portfolios to round out their exposure to the overall stock market. Still others like to tilt their portfolios toward small caps after a period of large-cap outperformance, such as we've seen during the trailing 12 months.
No matter the motivation, investors seeking small-company exposure can begin their search with our shortlist of the best small-cap funds, or those funds that earn a Morningstar Fund Analyst Rating of Gold.
Half of our Gold-rated funds follow passive approaches. All of these passive strategies offer low-cost diversified exposure to small caps--but that's where the similarities end.
The most "traditional" index fund of the group, Vanguard Small Cap Index VSMAX, tracks the CRSP US Small Cap Index. The CRSP index is among the most widely diversified small-cap indexes, including all stocks that fall between the 85th and 98th percentile in terms of market cap of the total stock market and meet minimum liquidity requirements. "The CRSP index is a more complete representation of the small-cap opportunity," says analyst Mike Rawson.
Vanguard Tax-Managed Small Cap VTMSX, meanwhile, isn't technically an index fund, but it qualifies as a passive investment. Manager Michael Buek closely matches the fund's holdings to the S&P SmallCap 600 Index, which carries a quality bias. But Buek can take some liberties with sales in the name of tax efficiency. "He can extend his holding periods in order to qualify for long-term capital gains treatment," notes Rawson. So, although it looks like a straightforward index fund on the surface, Vanguard Tax-Managed Small Cap can deviate from the index during periods of redemption, when Buek would be focusing on limiting the tax impact of sales.