Small-Cap Index Funds Have Delivered Surprisingly Strong 12-Month Returns. Here's What That Means for Investors.

Challenging the belief that only mega-cap stocks drive the market, small-cap index funds have quietly delivered impressive 12-month returns, with small-cap index products posting excellent trailing one-year results across major markets. For example, as of June 26, the State Street Small-Cap SPDR ETF (NYSEMKT: SPSM) -- a fund tracking the S&P SmallCap 600 -- had delivered a 36.9% trailing 12-month total return.

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Why small-caps might outperform -- and how investors can benefit

In a world where giants like Apple, Microsoft, and Nvidia are leaders, it may be difficult to understand why crowds would be drawn to diversify their portfolios by adding small-caps. Common reasons include:

• High growth potential: Due to their smaller size and greater room for expansion, small-cap stocks have the potential for significant growth. Because these companies are in the early stages of growth and may offer innovative products, services, or business models, there is an opportunity for rapid stock price appreciation.
• Higher risk -- higher reward: Small-caps tend to be less diversified, more sensitive to economic cycles and interest rates, more reliant on external financing, experience a higher failure rate, and are far more volatile than larger companies. It's precisely for those reasons that investors expect higher returns for accepting these risks.
• Low cost: Despite higher risks, the best small-cap index funds typically have low expense ratios, leaving investors with more money to capitalize on opportunities.
• Undervalued opportunities: Smaller companies are often overlooked, creating opportunities for investors to gain a competitive advantage by identifying hidden gems before they're widely recognized.
• Mergers and acquisitions: Small-cap stocks are often targets for larger companies looking to expand their market presence. When a larger company acquires a small-cap company, existing shareholders can benefit through improved liquidity and landing in a less risky position, and from a takeover premium.
• Diversification and balance: For an investor looking to diversify and balance their portfolio, small-cap index funds can help reduce concentration in large-cap stocks by adding a new source of returns. However, because small-caps also increase volatility, they are best used as a complement rather than a primary holding.
• Flexibility: Smaller companies are typically better positioned to respond more quickly to changing market conditions and capitalize on emerging opportunities. Without multiple layers of hierarchy, decisions can quickly be made on the ground -- especially compared to larger, more bureaucratic corporations.

Before investing in any small-cap company, make sure you understand the risks inherent to emerging small-caps, research thoroughly, choose carefully, and adjust your expectations accordingly.

Dana George has positions in Apple. The Motley Fool has positions in and recommends Apple, Microsoft, and Nvidia. The Motley Fool has a disclosure policy.