Small Caps Undervalued?


Small-cap indexing works best when small stock returns exceed those of large stocks. Should there be a resurgence of the small-caps, investors would be better off investing in small-cap index funds rather than an actively managed portfolio of small stocks.

The two main reasons:

  • Actively managed small-cap funds tend to have some degree of large-cap exposure for diversification purposes.
  • Lower fees charged by index funds do not detract as much from performance.

As large-cap growth stocks have led the bull run of the '90's, the S&P 500 index funds have beaten more than three-fourths of the active managers on average. The S&P 500 funds have by far been the most popular indexing vehicles used by investors. But as the large-cap leadership declines, active managers, who tend to be biased towards small and mid-sized stocks will most likely outperform the index.

"Actively managed funds always do better when small- and mid-cap stocks do better," says Don Phillips, CEO of fund-rating firm, Morningstar in an article published in "Mutual Funds, Mid-Year Forecast," August 1999.


But don't get him wrong; he does not mean that active managers will do better than indexing. He means to say that active managers will most likely beat an S&P 500 indexing strategy. But that does not rule out small-cap indexing.

Because of the recent dominance of large cap performance, large cap indexing has looked much better than one would expect while small cap indexing much worse. But a resurgence of small stocks will tilt the scales in favor of small-cap indexing at the expense of large-cap indexing. Since most small fund managers dabble in large cap stocks, they would have a hard time matching the return of a small-cap index fund.


"The advantage of indexing is even more impressive in small caps. Buy/sell spreads start at about 1 percent and increase as company size falls. This leads to an index advantage of about 2.5-3.0 percent," writes Dr. William Bernstein in his article, "When Indexing Fails."


Morningstar's numbers are further proof of indexing's long-term benefits. The average Small Blend Fund has an expense ratio of 1.44% and turnover of 72% while Vanguard's Small Cap Index Fund charges just 0.24% and has a turnover of about 29%.

It is impractical to ignore indexing in any market environment. Small-cap index funds make a lot of sense to capture the returns of the small-cap sector's imminent boom.

"The small-cap arena will be the best place to be over the next couple of years. It is coming off incredible undervaluation that really hasn't been seen in post-World War II market history," says Ed Larsen, Chief Equity Officer of the AIM Family of Funds.