X-Plained: How to Invest in US Small Caps

Investing in small cap stocks can provide exciting opportunities for growth. For Australian investors, US small caps which offer a higher exposure to the financial, health care and industrial sectors, can provide an avenue to broaden their portfolios beyond the concentrated sectors of the Australian market. Plus, US small caps have a number of unique characteristics which can help complement existing larger cap holdings in a portfolio.

Let’s X-Plain:

  • What are small caps?
  • Why invest in US small caps?
  • What considerations are there for investing in small caps
  • Why use an ETF to gain exposure to US small caps

What are Small Caps?

While there is no ubiquitous definition for small caps around the world, generally small cap stocks are companies with a market capitalisation between $500 million and $2 billion. For context, companies with capitalisations more than $10 billion are large caps and upwards of $200 billion are mega-caps (such as Apple, Meta, or Nvidia).

Small cap companies are often in the early or growth stages of their business life cycle, which makes them potentially higher risk but also capable of offering higher returns compared to larger, more established companies. Small cap stocks are generally considered more volatile because they tend to have smaller market footprints, fewer resources, and less brand recognition than their larger counterparts.

Why Invest in US Small Caps?

Small caps can be highly innovative and agile, able to adapt more quickly to market changes and capitalise on emerging opportunities. Often, small cap companies are poised to grow rapidly, and many of today’s largest corporations started as small caps. Investing in small cap stocks provides an opportunity to tap into this growth potential.

US small cap stocks have historically shown strong performance during times of economic recovery. These companies are often more resilient and adaptable, which can help them thrive during periods of domestic growth. The US market is home to some of the most dynamic small cap stocks globally, and many of these companies can benefit from favourable macroeconomic trends like interest rate cuts or domestic economic expansion. During periods of monetary easing, when interest rates are lowered, the cost of borrowing decreases, potentially enabling small cap companies to reinvest and innovate.

For Australian investors, US small caps can provide diversification in two ways. Firstly, it can help minimise home bias in a portfolio as many Australians heavily invest in the local share market rather than international ones. Secondly, for those already investing in US equities, small caps can provide diversification away from large or mega cap stocks which dominate the US market.

What Considerations are There for Investing in Small Caps

While small cap stocks offer significant growth potential, they come with unique risks that investors should consider.

One of the primary risks is volatility. Small cap stocks can experience significant price swings due to their size (smaller market capitalisation), lack of liquidity, and vulnerability to economic or market changes. This volatility can be unsettling for some investors, especially those with shorter-term investment horizons.

It is important to note some smaller cap stocks may have limited track record or trading history. Unlike large-cap companies, which generally have a long history of financial performance and stability, small caps may lack this data, making it more difficult to assess their long-term viability. Additionally, small-cap companies can face challenges related to accessing capital, scaling their operations, and maintaining profitability.

For Australian investors, another consideration is currency risk. By investing in US small caps, you are exposed to exchange rate fluctuations between the US dollar and the Australian dollar.

Why use an ETF to Gain Exposure to US Small Caps

An ETF, or exchange-traded fund, is a powerful tool for accessing US small cap stocks.

Rather than investing in a single small-cap company, which may be highly volatile or risky, a US small cap ETF can offer exposure to hundreds of small cap stocks in one trade by tracking a small cap index such as the Russell 2000 Index – one of the most established small cap indices in the world. This diversification reduces the risk of concentrated exposure to any one company and helps mitigate some of the volatility associated with individual stocks.

Moreover, ETFs offer cost-efficiency. Actively managing a portfolio of small-cap stocks can be time-consuming and expensive. In contrast, ETFs are passively managed, resulting in lower management fees, making them a more affordable way to access a diversified portfolio of US small caps.

Small Caps with Big Opportunities

By investing in small caps, you can access a dynamic segment of the market that holds significant growth potential, particularly during favourable economic conditions. While small-cap stocks come with risks, ETFs like RSSL offer a disciplined, cost-effective way to diversify your portfolio and capture long-term growth opportunities.

Related Fund

RSSL: The Global X Russell 2000 ETF (ASX: RSSL) invests in approximately 2000 of the smallest stocks, by market capitalisation, listed in the US.