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Our Favorite Passive Supporting Players

A low-cost passive fund can be a great way to get smaller-cap exposure.

This article is part of Morningstar's Guide to Passive Investing special report.

For many investors, a big part of the rationale for including small- and mid-cap stocks in a portfolio is their higher return potential. In contrast to their larger-cap, more-mature peers, smaller-cap companies are often more nimble and have greater growth opportunities ahead of them, which can equate to higher long-term returns. But they often have a higher risk profile as well: Their revenue and cash flows are often less consistent and their stock price can be volatile.

Indeed, smaller-cap companies don't always move in lock-step with large-cap firms. And this is another reason an allocation to smaller caps can make sense. According to modern portfolio theory, an investor can optimize his or her portfolio's risk/return by selecting combinations of investments and asset classes that are not perfectly positively correlated (as measured by correlation coefficient). Such a combination of assets is likely to do reasonably well in a variety of different environments, because as one asset is falling, another may be rising.

Due to their higher potential for loss, however, it's good to limit your exposure to small- and mid-caps to a smaller portion of your overall portfolio--what we at Morningstar refer to as "satellite" positions. The market-cap breakdown of the stock market can be a good starting benchmark for rightsizing one's exposure to small and mid-caps. Morningstar defines large caps as the top 70% of companies trading in the U.S. market by market capitalization (companies with market caps above roughly $17 billion). Mid-caps are the next 20% by market cap (which encompasses companies above $4 billion but below $17 billion). Small caps, as defined by Morningstar, are the smallest 10% of the U.S. market, or companies with market caps below $4 billion (but above $1.2 billion).

If you have a portfolio saved in Morningstar.com's

tool, it's easy to see how much exposure to small and mid-caps you already have. It's possible that you don't need a satellite fund if you already have plenty of exposure to smaller-cap companies in your portfolio. For instance, a total market index fund such as Gold-rated

can show you the percentage of your equity exposure that falls into each square of the style box, which helps you get a handle on how your portfolio is allocated across market cap and equity style.)

If adding a satellite holding focused on smaller caps makes sense in your case, though, here are some low-cost, highly rated passive funds that could fit the bill.

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