The Standard & Poor's 500 index may be down more than 11% year to date, but small-cap exchange-traded funds have been holding their ground. The respective year-to-date declines of 2.5%, 1.7% and 0.7% turned in by the Vanguard Small Cap ETF ( VB), the iShares Russell 2000 Index ( IWM), and the iShares S&P SmallCap 600 Index ( IJR) have left these funds in far better standing than the broader markets and most other ETFs. Only 17.4% of the 814 ETFs tracked by Morningstar so far in 2008 have been able to make it into positive territory. The past several weeks have been particularly favorable for these small-cap ETFs. Since July 15, these three small-cap ETFs have surged 10.6%, 12.1%, and 11.6%, respectively. The S&P 500 has improved only 4.6% over the same time period. It might be too early to tell, but if the market begins to break out of its prolonged slump these funds could have even more upside. "We have always looked at small-cap stocks as being the beneficiaries of early-stage economic recoveries," says Larry Glazer, a managing director for Mayflower Advisors. "The challenge is to try to determine if that is where we are headed." Some of the holdings of these small-cap ETFs include companies such as Alpha Natural Resources ( ANR), Ansys ( ANSS), Energy Conversion Devices ( ENER), and Walter Industries ( WLT). Small-cap ETFs carry some distinct benefits as well as risks when compared with ETFs that are dominated by large-cap names. "Small caps have far less currency exposure," Glazer says. "They are also significant beneficiaries in times of declining energy prices." The recent turmoil in the credit markets could make for a hangover effect that could hit hard many of the companies that make up these small-cap ETFs. "One concern that I have in general for small-cap companies is that they might not have access to capital like large caps because of the credit crunch we are in," says Glazer. "We also don't think that small-caps are much of a relative bargain in this market."
For long-term investors looking to add some growth potential to their portfolios, these small-cap ETFs might prove to be an effective way to gain that exposure. Bob Auer, senior portfolio manager of the Auer Growth Fund ( AUERX), has a long-term outlook that is particularly bullish on small-cap stocks. In looking for stocks to add to his portfolio, Auer scours all 9,000 or so stocks listed on U.S. exchanges. "We are a true go-anywhere fund and have about half of our portfolio in small-cap stocks right now," he says. "We are in small-cap stocks because that is where we are finding the growth." For investors looking to add some small-caps, but are not sold on ETFs, Auer has a couple of names in his portfolio that he believes are poised for mega-growth. To make it into his portfolio, a company must have earnings-per-share growth of at least 25%, sales growth of 20%, and typically a forward price-to-earnings ratio of 12 or less. Auer likes Cubist Pharmaceuticals ( CBST), a biopharmaceutical company that focuses on making novel anti-infectives for use in hospitals and other acute care environments. It was Auer's top holding as of July 31, and is a component of each of the small-cap ETFs mentioned. "They have produced one of only two truly new antibiotics in the last 35 years," he says. Another name Auer likes in the small-cap world is LMI Aerospace ( LMIA). The provider of engineering services and structural components to the aerospace industry is coming off a record second-quarter in which earnings per share rose by 73.1% on a 91.4% pop in sales from a year earlier.