Today we are answering the question: What is the best small cap growth ETF? Vanguard has two of the best ETFs in this space. VBK is a better lower cost option, but VIOG tracks a more effective index for small cap growth and is the superior pick in my opinion.
What is Small Cap Growth?
Market Capitalization Breakdown
A small cap, or “capitalization”, ETF simply means that the ETF will only invest in stocks that are below a certain market capitalization level. There isn’t a hard and fast rule for what is small, medium, or large. But the general consensus seems to be a market capitalization of:
- Large Cap – Greater than $10bn
- Mid Cap – Between $2bn and $10bn
- Small Cap – Below $2bn and (usually) above $300m
Growth Investing
The “Growth” portion of a small cap growth ETF means that it purchases companies that have “growth” characteristics. What does this mean exactly?
There isn’t a standard definition of what a “growth” stock is. But growth investors tend to target companies have higher prospects for future growth versus their current earnings. Some of these include companies that have:
- High Price/Earnings Ratios
- High Price/Book Ratios
- High Price/Sales Ratios
- Low Return on Equity
- Low or zero Dividend Yields
The general idea is that you’re buying companies that are projected to grow at high rates in the future. You are not so much purchasing them based on their past or current performance. Growth stocks are companies that have higher multiples described above, or may not be profitable at all. But this all comes with higher prospects for growth, thus elevating their multiples.
Why Can Small Cap Growth Be A Superior Investment?
Small Cap Out-performance of Large Caps
Over long periods of time, albeit not recently, small cap companies have outperformed large cap companies. Why is this? In general, it’s the level of risk associated with small cap companies. Small cap companies carry more risk as they do not have the financial might of an Apple, Amazon, PG, etc.
Therefore, when discounting cash flows and valuing small cap companies, investors place higher discount rates on them. This depresses their share prices versus larger cap companies (all else equal).
But with higher risk comes higher reward. On the aggregate, this means that investors taking more risks on small caps have been historically rewarded with higher returns.
Value Stocks vs. Growth Stocks
The data is less clear as to whether value stocks outperform growth stocks. The shift between the two is very cyclical and depends on macroeconomic factors.
However, as an investing style, growth stocks are very popular with an investor looking to purchase companies with high growth potential. These companies are generally purchased when investors are expecting a longer term bull market as it gives growth stocks more of a runway to perform. Generally in a more rocky environment, growth stocks perform worse than value stocks.
When coupled with small cap companies, growth investing provides a much higher risk profile than typical investing. You are combining an already risky area in small caps, and mixing them with an even more risky area in growth.
What is the Best Small Cap Growth ETF?
We’ve now established why small cap growth investing can be an effective strategy. Let’s then answer the question: What is the Best Small Cap Growth ETF?
My two favorite ETFs in this space are VBK and VIOG and both for different reasons.
Vanguard Small-Cap Growth ETF – Ticker: VBK
VBK is your simple, effective, and low-cost ETF that tracks the CRSP US Small Cap Growth Index. This is a very simple index that tracks a few fundamental ratios and selects companies that have “growth” characteristics. This ETF is passively managed, meaning that it has a very low expense ratio of 0.07%.
The biggest issue with VBK is that it actually doesn’t invest in small cap companies as much as you’d think. As of writing this article, only 51.50% of its assets are invested in small cap companies. The rest are in larger, mid cap stocks. This dilutes the strategy of small cap growth.
All in all, this is a solid fund but stumbles a bit with the execution of its desired strategy.
Pros: Lower expense ratio.
Cons: Lower weight towards small cap stocks.
Vanguard S&P Small-Cap 600 Growth Index Fund – Ticker: VIOG*
For an investor looking for a purer small cap growth index fund, VIOG is the way to go. As opposed to VBK, VIOG (as of writing this article) invests 72.10% of its assets in small cap companies. This is a much more effective weight towards small cap companies and therefore better executes on the strategy.
There are only two downsides, albeit extremely minor. One is the higher 0.15% net expense ratio of VIOG vs. the 0.07% of VBK. The second is that VIOG has a much lower net asset value of 696m vs. 15.5bn of VBK.
This means that VIOG is less liquid. But as a longer term investor not day trading or trading options, this is not an issue.
All in all, VIOG is, in my opinion, the best small cap growth ETF.
Pros: Better criteria for selecting stocks in the fund.
Cons: Higher expense ratio and lower net asset value/liquidity.
Bottom Line
So you should now know why small cap growth investing can be an effective, albeit risky, strategy. In terms of the best small cap growth ETF, my personal favorite is VIOG, but VBK can also roughly do the job.
Thanks as always for reading!
DISCLAIMER – THIS ARTICLE IS NOT FINANCIAL ADVICE. THIS ARTICLE DOES NOT CONSTITUTE A BUY, SELL, OR HOLD RECOMMENDATION ON ANY SECURITY MENTIONED HERE. THIS ARTICLE CONSTITUTES MY OPINION AND NOT A STATEMENT OF FACT. ALL INFORMATION REGARDING THE FINANCIAL SECURITIES MENTIONED IS ACCURATE AS OF JANUARY 19, 2024. DO YOUR OWN RESEARCH.