Everyone wants the "next big thing." It is human nature to look at Nvidia or Apple and wish you had a time machine to go back to 1999. But honestly, chasing individual winners is how most people lose their shirts. If you're looking for growth that actually has some teeth, you have to look at the little guys. Specifically, the Vanguard Small Cap Index.
Small caps are companies that usually have a market value between $2 billion and $10 billion. They are the scrappy teenagers of the stock market. They grow fast. They break things. Sometimes they fail miserably, which is exactly why buying them through a diversified index like Vanguard’s is basically the only way to sleep at night.
The CRSP US Small Cap Index: What's Under the Hood?
Most people assume "small cap" means the Russell 2000. It doesn't. Not here, anyway. Vanguard’s flagship small-cap product, specifically the VB ETF or the VSCIX mutual fund shares, tracks the CRSP US Small Cap Index.
This matters because CRSP (the Center for Research in Security Prices) handles things a bit differently than Russell. The Russell 2000 is famous for its "June reconstitution," a day when the index rebalances and every hedge fund on Wall Street tries to front-run the trades. It’s chaotic. It’s expensive for the fund.
Vanguard’s use of the CRSP index is different. It uses "banding." This means if a company grows a little bit too large, the index doesn't just dump it immediately. It waits. It lets the winner run a bit before moving it to a mid-cap category. This lowers turnover. Lower turnover means fewer taxes for you and lower trading costs for the fund. It’s a boring technical detail that makes you a lot of money over twenty years.
Why Small Caps Feel So Violent Right Now
If you’ve looked at your portfolio lately, you’ve probably noticed that small caps haven't exactly been the stars of the show compared to the "Magnificent Seven." Interest rates are the culprit.
Smaller companies usually need more debt to grow. When the Fed keeps rates high, that debt gets expensive. Fast. While a company like Microsoft is sitting on a mountain of cash, a small-cap biotech firm or a regional manufacturing plant is feeling the squeeze of a 7% or 8% loan.
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But here is the thing: small caps are historically cheap compared to large caps. We are seeing valuations that look like the post-dot-com bubble era. According to data from Jefferies and various Vanguard market outlooks, the valuation gap between the Vanguard Small Cap Index and the S&P 500 has rarely been this wide.
You're basically buying the "rest" of the economy at a discount.
The Risk of the "Zombie" Company
We have to be real for a second. There is a dark side to small-cap investing that the brochure won't tell you. About 40% of the companies in the Russell 2000 are currently unprofitable. They are "zombies"—companies that only stay alive by issuing more debt or selling more stock.
Vanguard’s index isn't immune to this, but because it leans slightly more toward the "mid-cap" side of small (the median market cap is usually around $6 billion to $7 billion), you often get slightly higher-quality companies than you do in a micro-cap fund. You're getting businesses that have moved past the "two guys in a garage" phase but haven't yet become the bloated giants that can't grow more than 3% a year.
Costs: The Vanguard Superpower
Jack Bogle, the founder of Vanguard, had one simple rule: you get what you don't pay for.
The expense ratio for the Vanguard Small Cap Index (VB) is typically around 0.05%. Compare that to some actively managed small-cap funds that charge 1% or more.
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If you invest $100,000 and it grows at 7% for 30 years:
- At a 0.05% fee, you end up with about $750,000.
- At a 1.00% fee, you end up with about $570,000.
That tiny 0.95% difference literally costs you $180,000. It’s a house. It’s a decade of retirement. It is the most expensive mistake you can make, and it has nothing to do with the stock market and everything to do with the contract you signed with your broker.
How to Actually Use This in a Portfolio
Don't go overboard. Seriously.
Small caps are volatile. They can go sideways for a decade while large caps soar, and then they can double in eighteen months. Most experts, like those at Morningstar or even the Bogleheads community, suggest a tilt.
Maybe 10% or 15% of your total stock allocation.
If you put 100% of your money into the Vanguard Small Cap Index, you will have a heart attack when the next recession hits. Small caps usually drop harder and faster than the big names. But they also tend to lead the way out of a recovery. When the economy starts to breathe again, these are the companies that pivot the fastest.
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The Mid-Cap "Sweet Spot"
One thing that surprises people about the Vanguard Small Cap fund is how much it overlaps with mid-caps. Because of the way CRSP defines the market, you aren't just buying tiny companies. You're buying "smid-caps."
This is actually a feature, not a bug.
Mid-sized companies are often in the "Goldilocks" zone. They have enough cash to survive a downturn but enough room to grow 10x. By holding the Vanguard Small Cap Index, you're capturing that transition period where a small company becomes a household name.
Actionable Steps for Your Portfolio
- Check your overlap. If you already own a "Total Stock Market" fund (like VTSAX or VTI), you already own these small caps. You don't need a separate small-cap fund unless you want to "overweight" them. If you want more aggressive growth, adding 10% in VB makes sense.
- Look at the tax-loss harvesting. Because small caps are volatile, they are great candidates for tax-loss harvesting in a taxable brokerage account. If the fund drops 15%, you can sell it, lock in the tax deduction, and buy a similar (but not identical) fund immediately.
- Automate and ignore. The worst thing you can do with small caps is watch the daily price. It’s a rollercoaster. Set up a monthly contribution to the Vanguard Small Cap Index and don't look at the balance for five years.
- Mind the Dividends. Don't expect big checks. Most of these companies reinvest their profits to grow. The yield on VB is usually much lower than a value fund or a large-cap fund. You are playing for capital appreciation, not income.
The reality is that the market moves in cycles. The last decade belonged to the tech giants. The next decade might belong to the smaller, leaner companies that are currently being ignored. Putting a portion of your wealth into the Vanguard Small Cap Index isn't about getting rich tomorrow; it's about making sure you own the winners of 2035 before they become too expensive for the rest of the world to buy.
Practical Next Steps:
- Review your current asset allocation to see if you are accidentally "large-cap heavy" (most people are because of how the S&P 500 is weighted).
- Compare the expense ratios of any current "Growth" or "Small Cap" funds you hold against Vanguard's 0.05% benchmark.
- Determine your "stomach for volatility" before moving more than 10% of your portfolio into small-cap territory, as the swings can be significantly more dramatic than the broader market.