Soooo, I am not sure about my thinking here, so please try and critique me. Just to be clear, I'm talking about small cap, not micro-cap or penny stocks. Legitimate, but small, companies.
A small cap index has all the regular advantages of index funds, low fees, etc. I am aware that they are considerably more volatile on the whole. But as companies grow to a certain size, they exit a small cap index and enter mid-cap range. Is this in effect a way to "buy low sell high"?
Maybe I'm not making myself clear here. Lets say Small Cap Index has companies X, Y, and Z, all currently valued at a market cap of 100M each and purchased at 10 dollars a share. Along with a generally growing market they grow to a size of 120M. All produce capital gains for the fund, but remain in the index because their size is still in the small-cap range. However, Company Z significantly outperforms the market. They are just a great, growing company, offering competitive products and services and a good price, whatever. So they grow to be worth 1Billion, out of the small cap range, and are sold by the small cap index to buy more small companies. In effect, you've bought low sold high.
I guess the opposite could be true of a declining company. Does anyone know if there are any safeguard against this in a passively managed small cap index? Like what if a passively managed small cap index fund had bought shares in Enron just as they were passing down. On the other hand, if a company has a short term valuation (market correction/speculation, whatever) that puts them into the small cap range, a passively managed fund could stand to profit when they swing back up.
It seems to me that another added advantage would be that by buying small cap, you avoid the risk of purchasing into clearly overvalued companies. We can argue about the valuation of Amazon and Facebook all day, but at the end of the day some of the value of these "large cap" companies has to be speculation. Or at least SOME COMPANY that is large cap has to be overvalued. A small cap index, it would seem to me, avoids this.