Small cap ETFs capture excess return in strong markets. Six months after the March 2009 nadir, the small cap benchmark iShares Russell 2000 Index (NYSEArca:IWM - News) is up 78%, compared to 58% for the large cap benchmark Standard and Poor's Depositary Receipts (NYSEArca:SPY - News).

Why the outperformance? Small cap ETFs are highly cyclical and volatile as a class, and ETFs capture this trait well with many variations. When investors are fearful they seek enterprises well-diversified by geography, business interest, and income stream: large caps. When investor sentiment improves, it is the reverse. Investors become less risk-adverse. They focus on growth potential and opportunity: small caps.

One measure of volatility is beta. IWM has a long-term beta of about 1.2, which means that for every point the benchmark SPY moves IWM is expected to move 1.2 points, up or down. IWM's beta over the last six months is slightly higher. Small cap beta has grown with overall market volatility. But beta does not mean outperformance. The markets' strong uptrend over the past six months mirrors a downtrend over the previous six months. On a 1-year basis, large and small cap ETFs have more similar returns:

The past 12 months have been unusually volatile. Small cap and large cap ETFs have traded at times with a wide spread. Overall performance on a 1-year basis however is similar. Timing these cycles correctly can add several percentage points of performance to a US equities portfolio. But assessing the appropriate time-frame is critical for this strategy. The chart below shows small cap and large cap ETFs have diverged over a 5-year period:

As the chart indicates, the period between March 2005 and March 2006 was particularly good for small cap exposure, creating opportunities for double digit gains. In March 2006 the spread between small cap and large cap narrowed sharply. The gap closed particularly rapidly after the summer of 2007, as investors became increasingly risk-adverse and the market sold. The far right of the chart shows that the gap between small cap and large cap is widening again (though it is still tighter than in the Spring and Summer of 2006).

Although they typically have very similar performance, small cap ETFs are not all alike. Small cap companies generally lie within the 750 to 2000 US stocks ranked by size. Investors seeking exclusively small companies will want to examine IWM. Vanguard's Small-Cap ETF (NYSEArca:VB - News) and SPDR Dow Jones Wilshire Small Cap ETF (NYSEArca:DSC - News) by contrast, are broad offerings pushing into mid-cap on one end and micro-cap on the other. iShares S&P600 Small Cap Index (NYSEArca:IJR - News), one of the most popular small cap ETFs by volume, targets a tight band of larger-than-average small firms. Fees range from .10% per year to .25%, with Vanguard leading. Although its net assets are smaller than some of the other funds, VB is the obvious choice for an investor with no specific index target in mind.

At first blush the SPDR and Vanguard products seem to use identical indexes. But despite both following stocks ranked 751-2500, the DJ Wilshire Small Cap Index and the MSCI US Small Cap 1750 Index commonly deviate by 1% per year. Likely causes are specific filtering methodologies which result in different industry sector weightings. A prudent course when deciding between any set of similar ETFs is to avoid those with high exposure to industries considered overvalued. We hesitate to call the MSCI index better for the long-term just because it outperforms over specific periods. Reversion to the mean will likely allow the DJ Wilshire index to catch up. Nonetheless, it remains instructive to see how indexing methodology can cause two seemingly identical ETFs to diverge by 1% per year.

Small cap indexes generally represent 8-15% of the total US stock market, so it is easy to overweight small cap. This may be a good idea when the markets are strong and investor confidence is high. But history shows that when investors become risk-adverse, overweighting small cap will produce inferior returns.

Plain Vanilla Small Cap ETFs

iShares Russell 2000 Index (NYSEArca:IWM - News)

SPDR Dow Jones Wilshire Small Cap ETF (NYSEArca:DSC - News)

Vanguard Small Cap ETF (NYSEArca:VB - News)

The major plain vanilla offerings are sufficient for most investors, but there are many more ETFs to consider. There are versions of plain vanilla small cap ETFs in growth or value styles (ie., high or low P/E portions of the market).

Focused Small Cap ETFs

SPDR Dow Jones Wilshire Small Cap Growth ETF (NYSEArca:DSG - News)

SPDR Dow Jones Wilshire Small Cap Value ETF (NYSEArca:DSV - News)

Vanguard Small-Cap Growth ETF (NYSEArca:VBK - News)

Vanguard Small-Cap Value ETF (NYSEArca:VBR - News)

iShares Morningstar Small Growth ETF (NYSEArca:JKK - News)

iShares Morningstar Small Value ETF (NYSEArca:JKL - News)

iShares Morningstar Small Core ETF (NYSEArca:JKJ - News)

iShares Russell 2000 Growth ETF (NYSEArca:IWO - News)

iShares Russell 2000 Value ETF (NYSEArca:IWN - News)

iShares MSCI EAFE Small Cap Index Fund (NYSEArca:SCZ - News)

iShares S&P SmallCap 600 Growth Index Fund (NYSEArca:IJT - News)

iShares S&P SmallCap 600 Value Index Fund (NYSEArca:IJS - News)

Rydex S&P SmallCap 600 Pure Growth ETF (NYSEArca:RZG - News)

Rydex S&P SmallCap 600 Pure Value ETF (NYSEArca:RZV - News)

Small Cap offerings have recently expanded into international markets:

International Small Cap ETFs

SPDR Russell/Nomura Small Cap Japan ETF (NYSEArca:JSC - News)

SPDR S&P Emerging Markets Small Cap ETF (NYSEArca:EWX - News)

SPDR S&P International Small Cap ETF (NYSEArca:GWX - News)

WisdomTree International SmallCap Dividend Fund (NYSEArca:DLS - News)

WisdomTree Europe SmallCap Dividend Fund (NYSEArca:DFE - News)

WisdomTree Japan SmallCap Dividend Fund (NYSEArca:DFJ - News)

An ever-increasing number of ETFs use fundamental financial ratios in proprietary picking formulas to try to beat the major indexes. They tend to cost .50% to 1% per year.

Fundamental Small Cap ETFs

Powershares Dynamic Small Cap Value Portfolio ETF (NYSEArca:PWY - News)

Powershares FTSE RAFI US 1500 Small-Mid Portfolio ETF (NYSEArca:PRFZ - News)

Powershares Zacks Small Cap Portfolio ETF (NYSEArca:PZJ - News)

First Trust Small Cap Core AlphaDEX Fund (NYSEArca:FYX - News)

FTSE RAFI Developed Markets ex-U.S. Small-Mid Portfolio ETF (NYSEArca:PDN - News)

PowerShares Dynamic Small Cap Growth ETF (NYSEArca:PWT - News)

PowerShares Dynamic Small Cap Portfolio ETF (NYSEArca:PJM - News)

RevenueShares Small Cap ETF (NYSEArca:RWJ - News)

There are also leveraged ETFs which go long or short on small caps, and these are strictly for experienced traders. While not cheap, leveraged ETFs typically are less expensive than broker margin loans per unit of leverage.

Leveraged/Short Small Cap ETFs

Rydex ExpressShares 2x Russell 2000 ETF (NYSEArca:RRY - News)

Rydex ExpressShares Inverse 2x Russell 2000 ETF (NYSEArca:RRZ - News)

ProShares Ultra Russell 2000 ETF (NYSEArca:UWM - News)

ProShares Ultra Russell 2000 Growth ETF (NYSEArca:UKK - News)

ProShares Ultra Russell 2000 Value ETF (NYSEArca:UVT - News)

ProShares UltraShort Russell 2000 ETF (NYSEArca:TWM - News)

ProShares UltraShort Russell 2000 Growth ETF (NYSEArca:SKK - News)

ProShares UltraShort Russell 2000 Value ETF (NYSEArca:SJH - News)

ProShares UltraShort SmallCap600 ETF (NYSEArca:SDD - News)

ProShares Short SmallCap 600 ETF (NYSEArca:SBB - News)

ProShares Ultra SmallCap 600 ETF (NYSEArca:SAA - News)

Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.