The sibling rivalry between large-cap stocks and smaller caps hasn’t been much of a rivalry at all. Exchange-traded funds tied to large caps such as the iShares Russell 1000 ETF (IWB) have enjoyed better absolute performance over small cap ETFs during the past three, five and 10-year period. But the market trend could be swinging in favor of smaller stocks.
Over the past six months, the iShares Core S&P Small-Cap ETF (IJR) has climbed an impressive 44% compared to just 27.5% for IWB over the same period. Mid-cap stocks, at least as measured by the SPDR S&P MidCap 400 ETF Trust (MDY), trailed IJR.
ETFs that target small caps with 2x and 3x daily leverage have done even better. The Direxion Daily Small Cap Bull 3x Shares (TNA) jumped 186.2% during the past six months while the ProShares Ultra SmallCap 600 ETF (SAA) has rallied 99.5%. Will the rally last?
If the post-coronavirus economic recovery continues, small caps will benefit as growth rebounds. Here’s something else: Small caps have history on their side: During the past four economic recessions, small caps outperformed large caps every single time.
An Invesco study found the Russell 2000 (small caps) beat the Russell 1000 (large caps) exiting the past four recessions by 3.3% during the subsequent three years and by 7.1% during the subsequent one year.
The upcoming January Effect could be another silver lining for small cap investors.
Stock prices have increased during January more than in any other month. Moreover, smaller stocks have tended to outperform their mid and large-cap peers during this particular month. The dominance of small caps in January can of course fail and it did in 1982, 1987, 1989 and 1990.
Top small-cap ETFs by assets includes the formerly mentioned IJR with $56.1 billion, IWM with $59.2 billion, Vanguard Small-Cap ETF (VB) with $37.6 billion and the Schwab U.S. Small-Cap ETF (SCHA) with $13.1 billion. Annual expense ratios for these small-cap funds range from 0.04% on the low end up to 0.19%.
The variances in small-cap index construction may seem unimportant, but the differences in approach are worth mentioning.
The VB fund, which tracks the CRSP U.S. Small Cap Index, extracts the bottom 2% to 15% of stocks by market size within the investable universe. CRSP indexes use a market-cap based breakpoint method, which is radically different compared to peers.
Unlike the CRSP approach, S&P and Russell indexes use a count-based strategy which is basically a quota for the index based on the number of stocks within it.
For example, the S&P Small Cap 600 is taken from the broader parent index, the S&P 1500. The 600 smallest stocks among the S&P 1500 get assigned to the small-cap index while the large caps join the S&P 500 and the mid caps go into the S&P 400.
These nuanced indexing subtleties partly explain the performance spread between small-cap ETFs. Over the past five years, VB has gained 88% whereas IJR has lagged behind at 77.8% gain. At least for now, it appears the CRSP method has been winning. Likewise, the iShares Russell 2000 ETF (IWM) gained 86.2%, which has slightly lagged VB on performance.
In summary, if small caps can continue their recent dominance, it’ll reconfirm to all that good things do come in small packages.
Ron DeLegge is founder and chief portfolio strategist at ETFguide, and is the author of “Habits Of The Investing Greats.”