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When you are seeking to increase the value of your investment portfolio, small is beautiful. Investors should purchase companys with small market capitalizations to enhance their portfolios. A careful evaluation of small cap core funds uncovered two attractive low-fee funds.

The Case for Small Caps

The small cap effect is a market anomaly supported by historical data and is not a groundless article of faith. The small cap effect is the observation of how small cap stocks have outperformed large cap stocks over long periods of time. The discovery of the small cap effect and the value effect by Fama and French won a Nobel Prize in economics.

Despite the evidence, the popular perception is that big companies have big advantages. Laypeople are fixated on large corporations and their seemingly increasing dominance over the world. They witness how companies engage in costly mergers and acquisitions to boost company size. Many business leaders pursue sales and asset growth aggressively, sometimes at the cost of earnings. These perceptions and behaviors mislead investors to think that large cap investments will outperform small cap investments. How can retail investors hope to see through these distractions to see that, at least historically, small is beautiful?

Investing in small caps requires mental discipline to ignore this misdirection. Investors need to suspend disbelief and stick to the evidence regarding small caps because the outperformance of small caps is contrary to popular notions.

Fund Evaluation

Investors can benefit from the small company effect by buying funds with low market capitalizations stock portfolios. Fortunately, investors seeking exposure to small cap stocks have many funds to choose from. They should select small cap core funds using the following criteria:

Low expense ratios. The less that investors pay in fund-level fees, the more they keep.

Holdings with reasonable price-to-book ratios. These funds should have a mix of value and growth holdings that leads to a mid-range PB ratio average for the portfolio.

Holdings with low market capitalization. These funds should hold small cap companys. There is even a micro cap effect, which seems to indicate that the lower the company capitalization, the greater the company size effect.

Financially strong holdings. Funds should be biased towards stocks with stronger financial positions that can weather bad times. Funds with more holdings which score as "safe" according to the Altman Z-score metric are preferable to funds with weaker holdings.

A collection of small cap core funds with expense ratios under 0.25% were evaluated based on their top 25 holdings. Key attributes of these funds and their holdings are listed below:

Fund

Expense Ratio

Avg P/B

Avg Market Cap ($ Millions)

Weight "Safe" Altman Score

D/E

ASCIX

0.18%

2.45

2840

52%

0.97

IJR

0.20%

1.86

2514

41%

0.60

IWM

0.20%

2.81

2966

57%

1.03

IWN

0.25%

1.59

2411

15%

1.04

JKJ

0.25%

1.89

2541

25%

0.79

NMSCX

0.20%

3.83

3212

57%

0.66

PSSIX

0.20%

1.77

2882

36%

0.57

SCHA

0.13%

2.89

3850

67%

0.60

SLY

0.24%

1.86

2514

41%

0.60

SWSSX

0.20%

2.26

2763

52%

0.58

TISBX

0.18%

2.28

4061

61%

0.80

VB

0.12%

2.95

4152

49%

1.02

VIOO

0.15%

3.75

3384

47%

0.60

Fund Selection

This assessment of each fund's top 25 holdings uncovers two standouts.

The iShares S&P Small Cap 600 Index (NYSEARCA:IJR) provides investors with an attractive portfolio while charging low fees. IJR holdings are identical to those of the SPDR S&P 600 Small Cap ETF , yet IJR lists a lower expense ratio. IJR's holdings are more towards the value end of the small cap spectrum, as can be seen by the low 1.86 average PB ratio of its top 25 holdings. Moreover, investors in IJR are purchasing a portfolio of smaller companies with smaller market capitalizations than are found in many peer small cap funds. Based on much of its top 25 holdings qualifying as "safe," this fund finds value without endangering its portfolio with excessively risky companies.

The Schwab U.S. Small-Cap ETF (NYSEARCA:SCHA) also stands apart from the list. Based on its top 25 holdings, a majority of its portfolio is allocated to "safe" companies and the average debt-to-equity ratio of its holdings is a low 0.60. The fund charges a very low 0.13% expense ratio as well. Though this fund's portfolio appears more stable than its peers, its holdings have a higher fraction of value companies and feature larger market capitalizations as well.

Investors should consider IJR as a low-cost small cap fund with a value tilt or SCHA as a more growth oriented blend. Either fund is an attractive way to add small cap exposure to an investment portfolio.

Source: Small Is Beautiful: 2 Great Small Cap Core Funds