While small-capitalization stocks have been outperforming, ETF investors shouldn’t chase this segment but consider more stability with large-cap stock exposure instead.
“Global small cap stocks have had a strong 2019 so far, outperforming large caps by more than three percentage points. This is not a rally worth chasing, in our view. As the pace of the global expansion slows, we prefer large cap equities. We favor exposures to firms with quality markers such as strong balance sheets,” BlackRock strategists led by Richard Turnill said in a research note.
The BlackRock strategists argued that since small-cap stocks tend to be more domestically oriented, smaller companies are more cyclical or have a greater sensitivity to changes in economic activity – global small caps’ relative performance has historically exhibited a close correlation with swings in global Purchasing Managers’ Index data.
However, global composite PMIs have mostly slipped over the past year, with small-cap performance following close behind. While small-caps surged along with the recent bounce-back in PMI data, the strategists warned that this may be more of a relief rally that could be short lived.
“We attribute much of the small cap move to multiple expansion amid the fading of key risks to the macro outlook – higher rates and escalating trade conflicts. More dovish monetary policy guidance from central banks globally and a lessening of perceived geopolitical risk have provided relief for risk assets – and for small caps too,” the strategists said.
“We see fewer catalysts for sustained small cap outperformance ahead,” they added.
Related: Tech Sector Helps Lift U.S. Stock ETFs; QQQ Up 2%
Balancing Risk & Reward
Given the current market environment, BlackRock argued that today’s late-cycle economic conditions of slowing growth and rising uncertainty should make investors take a more carefully balanced risk and reward approach to portfolio construction.
“We advocate building portfolio resilience through high quality exposures and caution toward lower-quality market segments, such as small caps. We favor large caps for their stronger balance sheets, more diverse businesses and greater operational flexibility,” the strategists said.
For example, investors can take on a simple, broad market exposure to the large-cap category through something like the iShares Core S&P 500 ETF (NYSEArca: IVV), which tracks the benchmark S&P 500 Index.
The iShares Morningstar Large-Cap ETF (JKD) focuses on high-quality companies. The underlying index measures the performance of stocks issued by large-capitalization companies that have exhibited average “growth” and “value” characteristics, as determined by Morningstar Inc.’s proprietary index methodology.
Additionally, the iShares Edge MSCI USA Quality Factor ETF (Cboe: QUAL) provides exposure U.S. large- and mid-capitalization stocks exhibiting quality characteristics based on quality screens for three fundamental variables, including return on equity, earnings variability and debt-to-equity.
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