With small-cap stocks making a stunning comeback since last fall, you might be thinking about buying into that rise with a small-stock index fund.

Think again.

Though indexing works well for large-cap stocks, small-cap index funds sport a noticeable shortcoming: To maintain so-called style purity, they must sell stocks that outgrow their corresponding index, which means investors can miss out on much of the rise of fast-growing companies while incurring capital gains taxes to boot.

You'll also find that indexing small-cap stocks is not the no-brainer that it is for large-caps. An

S&P 500

fund is practically your only choice for a large-cap index fund. (Yes, you can choose a total market index, like the

Wilshire 5000

, but it's still dominated by stocks from the S&P 500.) With small-caps, you'll have to choose from a handful of different indices with widely varying returns.


Russell 2000

appears to be the index of choice. Approximately $11 billion is indexed to it, according to

Lehman Brothers

. Close behind is the

Standard & Poor's SmallCap 600

index, tracked by funds holding about $8 billion in assets. There's also the

Schwab Small-Cap Index

, which is tracked by the $1.3 billion


Schwab Small-Cap Index fund.

Usually, variety is a blessing. In the case of small-stock index funds, it's confusing.

The Russell 2000 and S&P 600 indices are constructed by

Frank Russell

and Standard & Poor's, respectively, to represent their definition of the small-cap market. The Schwab index tracks the second 1,000 largest publicly traded U.S. companies.

In practical terms, the Russell 2000 obviously gives you twice the diversification of the Schwab index and more than three times that of the S&P 600. And based on the sector weightings of funds that track these indices, you also get more technology via the Russell index than through the other two. At the end of 1999,

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Vanguard Small Cap Index, which tracks the Russell 2000, had 28.4% of its assets in tech, compared with 27% for the

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Dreyfus Small Cap Stock Index, which tracks the S&P SmallCap 600, and 21.7% for the Schwab index.

The Schwab index fund has the smallest median market cap, $748 million, compared with about $870 million for the other two index funds.

And, not surprisingly, returns of funds that track these indices vary wildly.

In 1999, the Vanguard Small Cap Index was up 23.1%, compared with a 12.1% return for the Dreyfus Small Cap Stock index. The Schwab fund beat them both, climbing 24.2%.

Again this year, these funds are not moving in tandem. Vanguard's Russell index fund is up almost 9%, ahead of the 7.2% gain of the Dreyfus S&P 600 fund and the 6% increase in the Schwab portfolio.

More important, small-cap index funds are being trounced by their actively managed counterparts. Typically, the small-cap indices are updated once a year -- not often enough to keep up with new companies hitting the market practically on a daily basis. Managers of nonindex-based small-cap funds, on the other hand, can stoke their returns with initial public offerings and very young, but fast-growing companies.

Over the last 12 months, the average actively managed fund returned 70.3%, while the average small-stock index fund was up 41.4%, according to


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"Indexing hasn't worked well in the short-term," says Morningstar senior analyst Scott Cooley. "The people who put together these indices are slow to move."

More broadly, small-cap index funds tend to be less tax-efficient than their large-cap counterparts, a result of being forced to sell stocks that grow too large.

"If a stock goes out of an index, funds follow suit automatically," notes Vanguard founder Jack Bogle.

That selling can possibly generate capital gains that could be passed on to investors.

If you own a small-cap index fund by itself, you've got a fund that must continually sell its winners. If you don't have a fund to catch these stocks -- say, a mid-cap index fund or a broad market fund -- you'll lose the growth possibilities of that stock once it leaves the index.

The Russell 2000, for example, rebalances in the middle of every year. Stocks that have become too big for the index move into the

Russell 1000

. Last year, stocks like

Network Appliance

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Exodus Communications




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left the index. Since July 1, all three of those stocks have soared more than 300%. (Network Appliance has climbed 535%.)

Rather than trying to construct an entire portfolio out of varying index funds, you're better off starting with a total stock-market fund, one that tracks the Wilshire 5000 index. This giant index represents the entire stock market -- large-, mid- and small-cap stocks.

That way, you own all the stocks in the market from the outset. You don't have to worry about losing a fast-growing stock when the index rebalances, and you won't end up paying taxes on a stock as it continues to grow.

"I would own small- and mid-cap stocks through an all stock-market index," says Bogle. "That's a hugely efficient way to invest. I think that's the best decision for my nickel."

A total stock-market fund, however, will give you heavy exposure to the large-cap stocks -- namely the ones already included in the S&P 500.

The S&P is about 70% of the Wilshire 5000 index in terms of market capitalization. If you already own a S&P index fund, you won't need the duplication you'll get in the wide Wilshire index.

Instead, you should opt for what's called an extended-market fund: These index funds typically track the

Wilshire 4500

, a small- and mid-cap index that includes everything that's not in the S&P 500. You can find these funds at several firms, including



T. Rowe Price

and Vanguard.

Those suggestions are for those of you who want to index small stocks. As I mentioned, active managers can add value with small-caps because they have the opportunity to go out and find undiscovered small companies.

Or you can have it both ways.

Schwab tells its clients to put 40% of small-cap exposure into an index fund and the remainder with an active manager.

Send your questions and comments to

deardagen@thestreet.com, and please include your full name.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.