Why Money is Rushing into Small Cap Stocks and ETFs

Small-cap stocks are having a bit of a resurgence after a rather tumultuous past year. Investors, who had dumped riskier stocks in favor of more defensive ones during the heightened volatility over much of the summer, are now piling back into relatively cheaper-priced equities, such as small caps and the exchange-traded funds (ETFs) that contain them.

The iShares Russell 2000 ETF, which tracks the Russell 2000 Index of stocks with smaller market capitalizations, saw its largest weekly inflows in nearly a year during the week that ended September 6. Those inflows totaled $1.5 billion and followed a $340 million inflow during the final days of August. Since bottoming out on August 27, the iShares ETF has rallied nearly 9% compared to the S&P 500’s gain of 5% over the same period.

While it’s only been a few weeks, the comeback is a positive sign after significant underperformance in recent years. The Russell 2000 index is down more than 7% over the past year while the S&P 500 is up nearly 4%. Over the past five years, the small-cap index is up just 36% to the broader market’s rise of 52%.

There is the possibility that the resurgence could be longer lasting if the Federal Reserve’s interest rate cut at the end of July is more than just a one-off and marks the beginning of a rate-cutting cycle. The Fed cut rates amid escalating tensions in the U.S.–China trade war and signs of a slowdown in the global economy. Markets and many analysts expect the Fed to cut rates again at its next policy meeting next week.

Judging by history, further rate cuts would be supportive of small-cap equities. During the first year following the start of a Fed rate-cut cycle, small caps have risen on average 28% compared with just 15% for large caps, according to investment banking firm Jeffries, per the FT. At a fundamental level, lower rates take a lot of pressure off of smaller companies, which tend to be more indebted than larger ones.

But it’s not just the prospect of lower rates that are attracting investors to small caps. They also look good from a value perspective. The very fears that drove investors into safe-haven and bond-like securities had the consequent effect of beating down the values of riskier assets. The market unease over the summer drove the valuation of the Russell 2000 to its lowest level compared to that of large caps in more than 15 years. 

Now, as there appears to be some forward progress on trade talks, investors are picking up small caps at relatively steep discounts. Jefferies expects small-cap stocks to outperform large caps by 6% over the next year. “They’re down on their butts,” Jefferies equity strategist Steven DeSanctis told the FT. “But you get a bit of positive reprieve around growth globally and no recession for the US, and [small-caps] are going to do well.”

Of course, relatively low valuations and lower interest rates will only take small caps so far. If there is going to be a sustained rally that can push them beyond their 2018 peak, it will likely have to be driven by underlying economic strength and healthy earnings. “At the end of the day, earnings growth drives returns and we do have to have a better economy for that to happen,” said Craig Stone, small-cap portfolio manager at Kayne Anderson Rudnick.