Best Small Cap ETFs: 5 Vanguard Funds Land In The Top 10

Small-caps have lagged large-caps pretty much non-stop since 2021. As I write this, the Russell 2000 index is still 7% below its late-2021 peak, even after the recent rally. There's a deep value aspect to small-caps right now (they're trading at about a 40% valuation discount to the S&P 500), but that hasn't mattered while the magnificent 7 stocks are controlling the market narrative.

Last week marked a potentially seismic shift. As I wrote earlier this week, the recent rally for small-caps looks more like a pure rotation from growth into value. It doesn't necessarily look like a super-bullish move. Given how economic conditions are trending and Powell's recent comments about potentially slowing growth, I think this is more likely a defensive shift within equities. Small-caps may not seem like a natural landing spot for investors playing defense, but since the group only trades at about 14 times earnings, it qualifies.

We've seen investors starting to chase those returns, based on recent ETF flow data. Whether that turns out to be a prudent move remains to be seen, but it's encouraging in the sense that it's getting investors to think about diversifying their portfolios. So many people are now heavily overweight to U.S. mega-cap tech, either by buying the stocks individually or just owning the S&P 500, that broadening their portfolios to include value, dividends and small-caps makes a lot of sense.

As a long-term investment, small-caps deserve consideration to some degree. As we've seen lately, they are a great diversifier and have a different risk, reward and cyclical sensitivity profile. Within the universe of U.S. small-cap ETFs, there are about 100 funds to choose from.

Ranking The Small Cap ETFs

As is the case with many of these rankings, the cheapest and most liquid ETFs tend to drift to the top. That means you'll see most of the spots being occupied by Vanguard, iShares and SPDR. In a lot of cases, going the route of cheap beta is the best way to dip your toes into the water for small-cap exposure. With so many aggressive, vulnerable and/or unprofitable companies, simply investing in a broad index to minimize idiosyncratic risk is recommended.

You could certainly augment that core position with something that's more of a moonshot, but these funds will make for a great core position.

Methodology And Factors For Ranking ETFs

Before we dive in, let's establish a few ground rules.

First, all of the data is used is coming from ETF Action . They have gone through the ETF universe to identify and categorize those ETFs used here. There are many that qualify and we'll be using their categorization as a starting point. Many thanks to them for opening up their vast database for my use.

Second, let's run down the factors I used in the ranking methodology.

• Expense Ratio - This is perhaps the most important factor since it's the one thing investors can control. If you choose a fund that charges 0.1% annually over a fund that charges 1%, you're automatically coming out ahead by 0.9% annually. You can't control what a fund returns, but you can control what you pay for the portfolio. Lower expense ratios equal more money in your pocket.
• Spreads - This relates to how cheaply you can buy and sell shares. Generally speaking, the larger the fund, the lower the spreads. Bigger funds usually have many buyers and sellers. Therefore, it's easier to find shares to transact and that makes them cheaper to trade. On the other hand, small funds tend to trade fewer shares and investors often need to pay a premium to buy and sell. Considering expense ratios and spreads together usually give you a better idea of the total cost of ownership.
• Diversification - Generally speaking, the broader a portfolio is, the better chance it has at reducing overall risk. A fund, such as the Energy Select Sector SPDR ETF (XLE), provides a good example. 45% of the fund's total assets go to just two stocks - ExxonMobil and Chevron. By buying XLE, you're putting a lot of faith in just those two companies. An equal-weighted fund, such as the Invesco S&P 500 Equal Weight Energy ETF (RYE), would score higher on diversification than XLE.

There are a few other minor factors thrown into the mix, but these are the main factors considered.

One thing that is not considered is historical returns. Most ETFs are passively-managed and are simply trying to track an index, not outperform. ETFs shouldn't be penalized for low returns simply because the index that they are tracking is out of favor at the moment.

I'm ranking ETFs based on more basic structural factors. Are they cheap to own? Are they liquid? Do they minimize trading costs? Do they maintain risk-reducing diversification benefits?

Being in the bottom half of the list doesn't automatically make a fund "bad". It simply means that due to a low asset base, a high expense ratio, a concentrated portfolio or some other factor, it poses additional costs or downside risks.

Best Small Cap ETF Rankings

As expected, the ultra-cheap small-cap ETFs dominate the top 10 with most of the sector, thematic and smart beta options falling a little lower on the list. Interestingly, it's not one of the big three issuers that grabs the #1 spot.

The top spot goes to the Schwab U.S. Small Cap ETF (SCHA) . This shouldn't be surprising because Schwab has essentially stepped in as the 4th ultra-low cost issuer with a lineup that includes 30 funds, total assets under management of more than $350 billion and a weighted average expense ratio of just 0.08%.

While the S&P 600 essentially tracks stocks 901-1500 in terms of market cap and the Russell 2000 captures 1001-3000, SCHA tracks an index that covers 751-2500. Therefore, you get just a touch more larger company exposure than you might get with the other popular indices, but the exposure is substantially similar.

Vanguard owns five funds on this list - the Vanguard Small Cap ETF (VB) , the Vanguard Russell 2000 ETF (VTWO) , the Vanguard Small Cap Value ETF (VBR) , the Vanguard Small Cap Growth ETF (VBK) and the Vanguard S&P Small Cap 600 ETF (VIOO) .

Does Vanguard really need three small-cap core ETFs in its lineup? Probably not, but investors sometimes have their preference of indices. VTWO and VIOO obviously track the major benchmarks. VB tracks the CRSP U.S. Small Cap Index, which targets the smallest 85th to 98th percentile of the U.S. market by market cap. VBK and VBR are offshoots of that index.

State Street's lone representative in the top 10 is the SPDR Portfolio S&P 600 Small Cap ETF (SPSM) , which is effectively a clone of VIOO. It's the lowest cost ETF in this segment, which gives it a clear advantage in these rankings. On the other end of that spectrum is the iShares Russell 2000 ETF (IWM) . It's easily the biggest and most liquid small-cap ETF, but that 0.19% expense ratio gets it dinged in a segment where there are multiple options at 0.05% or less.