Can Small-Cap Index Funds Follow Bigger Siblings?

Large-company index funds, long the darlings of this bull market, now must share the limelight with some stunning kid sisters.

They track indexes of the small and mid-size companies that have outperformed their larger siblings of late.

"In recent months there's been a noticeable uptick" into small- and mid-cap stock funds, says Brian Mattes, spokesman for the Vanguard Group in Malvern, Pa.

Vanguard and others have made investors happy by offering low-cost funds that match the Standard & Poor's 500 index of big companies. Now investors are finding that the same strategy can also work for the multitude of lesser-known stocks that populate indexes like the Russell 2000 or Wilshire 4500.

These funds run counter to prevailing wisdom that the small-stock universe requires a skillful guide, a fund manager who actively picks stocks. Still, analysts warn not to snub the indexers who follow firms with less than $1 billion in capitalization (share price times number of shares outstanding). Among the reasons:

* They offer solid ballast. They diversify across a broad market by passively mimicking the profile of their chosen index.

* They tend to avoid lesser-known, riskier companies.

* They pose lower management expenses and taxes, because they trade fewer shares than managed funds.

* They are the industry's auto-pilot funds. The simple formula allows investors to avoid tedious comparison shopping.

Still, there are hidden holes in these funds, making them riskier than most investors perceive, analysts say.

Index funds by definition hold little or no cash, so they lack a cushion when the market sinks.

"These funds are bound to perform worse in a bear market because they don't hold cash," says Sheldon Jacobs, editor of The No-Load Fund Investor.

Index boosters disagree.

"There's a false sense of security with actively managed funds," says Mr. Mattes at Vanguard. "There's no guarantee a manager ... will be able to run to cash and protect you before a decline."

By some measures, small-cap index funds are more volatile than actively managed issues. A Morningstar study early this year found that although small-cap index funds hold a slight edge in total return against actively managed funds, they lag behind in risk-adjusted returns. In other words, they fare worse in bear markets.

The study of five-year performance underscores the importance of patience.

"You've got to invest in index funds for the long term," says Tracy Gordon, spokeswoman for Charles Schwab in San Francisco. "If you're going into it like you'd approach a Las Vegas casino, forget it."

In shopping for an index fund, seek low annual expenses and consider the index a fund tracks: Vanguard promotes its Wilshire 4500 fund as a play on both mid- and small-cap stocks, whereas the S&P indexes tend to focus on one or the other.

Key to Fund Objectives

Bal - Balanced: Reduces risk by investing in bonds, which are generally more conservative, as well as stocks.

Cap - Capital Appreciation: Aims at maximum returns, often by frequently selling stocks and buying new ones. These portfolios often turn over all their positions annually, borrow money to buy stocks, buy unregistered securities, and buy options - all of which are considered risky strategies.

Emerg - Emerging Market: Invests mostly in emerging-market nations.

Env - Environmental: Invests at least 65 percent of its portfolio in companies whose businesses, in the fund's opinion, contribute to a cleaner and healthier environment.

Eq Inc - Equity Income: Seeks relatively high current income and share-price growth by investing in dividend-paying stocks.

Eur - European Region: Invests in securities of companies based or operating primarily in Europe.

Fin - Financial Services: Has at least 65 percent of its portfolio in companies such as banks or insurance and brokerage firms.

Fixed - Fixed Income: Invests more than 75 percent of assets in fixed-income issues such as money-market instruments, bonds, and preferred stocks.

Global: Invests at least 25 percent of its portfolio in securities traded outside the US and may own American securities as well.

Gold: Invests mostly in gold mines, mining finance houses, gold coins, or bullion.

Growth: Invests in companies whose long-term earnings are expected to grow significantly faster than average.

Gro/Inc - Growth & Income: Combines the goals of share price growth and income from dividends and bonds.

Hlth - Health/Biotechnology: Invests mostly in health-care and biotech firms.

Inc - Income: Seeks high current income by investing in bonds, dividend-paying stocks, and money-market instruments.

Intl - International: Invests in stocks based primarily outside the US.

Japan: Concentrates its investments in Japanese companies.

Lat - Latin American: Invests in companies operating in Latin America.

Micro - Micro-cap: Invests in very small companies, primarily those with market capitalizations of $300 million or less.

Mid - Mid-cap: Invests in mid-size companies, usually with market capitalizations or revenues between $800 million and the average capitalization of the Wilshire 4500.

Misc - Specialty & Miscellaneous: Limits its investments to a specific industry, such as transportation, retailing, or paper.

Nat - Natural Resources: Invests mostly in natural-resource stocks.

Pac - Pacific Region: Concentrates on companies based or operating in the Pacific.

PacXJ - Pacific Ex-Japan: Concentrates on companies in the Pacific, but not Japan.

Small - Small Company: Limits its investments to small-size companies.

Tech - Science & Technology: Invests mostly in science and technology stocks.

Util - Utility: Invests 65 percent of its portfolio in utility shares.