Small-cap index funds are mutual funds that are invested in securities of various companies based on the chosen benchmark indexes. The companies included will generally have capitalization of less than $5 billion US Dollars (USD). The managers of the index funds select securities to try and replicate the performance of a particular market index. The funds are passively managed funds, so they typically have lower expenses than actively managed funds. There are risks associated with investing in small-cap index funds, and investors should always thoroughly read the prospectus prior to investing.
Investment holdings in small-cap index funds are mostly for companies with small capitalization of less than $5 billion USD. These companies are generally more risky than mid and large capitalization companies because they are not as well established. This also means that the funds that invest in small-cap companies are generally more aggressive but have potential for higher returns than mid-cap and large-cap funds.
Index funds follow chosen benchmark market indexes, such as the S&P 500, to try and replicate the performance of the index rather than trying to outperform it. The indexes are used as a guide for which securities to invest in, so small-cap index funds would follow indexes for small companies. Fund managers will usually buy the same holdings and in the same proportions as are in the selected indexes to try and achieve the investment objectives. In some cases, they will just buy a representative sample of the companies included in an index, and they might include stock options or futures as well.
Small-cap index funds are passively managed, as opposed to actively managed mutual funds. There is less trading involved within the funds because the holdings track a particular index, so securities are only added or dropped when the holdings in the index change. Usually this means the funds will have lower operating costs than actively managed funds. The fees for index funds can vary, however, so the returns will also vary accordingly. In addition, index funds will typically have lower realized capital gains than actively managed funds, which can translate to favorable tax implications.
The risks associated with index funds depend on the securities they are invested in. The various indexes pose different levels of risk due to the securities contained within them. Index funds are also less flexible than non-index funds because they follow the indexes regardless of market conditions. This means the funds can be slower to react to market changes and declining prices. Investors should always thoroughly read the prospectuses for small-cap index funds before investing to fully understand the risks and make sure the funds meet their investment goals.