Should You Reconsider Your Market Cap Exposure?

Many emerging markets have been doing poorly this year. And U.S. stocks have hardly impressed this year: The S&P 500 has gained just 2.2% year to date.

But maybe the American stock market can still offer exciting opportunities among companies with lower market capitalizations.

Small caps and mid caps
If you want to start positions based on market cap, there are two specialized indexes to consider first: the Russell 2000 and the Russell 1000. The Russell 2000 is made up of 2,000 small-cap companies, while the Russell 1000 targets the 1,000 largest U.S. stocks and thus consists of mid caps and large caps.

There are two exchange-traded funds that track these indexes: iShares Russell 2000 (NYSEMKT: IWM  ) and iShares Russell 1000 (NYSEMKT: IWB  ) , which have made respective gains of 2% and 2.4% year to date. The Russell 1000's correlation with the S&P 500 is higher, making it less appealing if you're looking for market-cap diversification.

Should you bet on small caps?
U.S. small caps have historically provided some diversification benefits, but can they actually prove more profitable? Well, since 1926, small-cap stocks have returned about 2% more than large-cap stocks. However, in recent decades, this margin of outperformance has narrowed. From December 1978 through February 2014, the small-cap Russell 2000 index has outpaced the Russell 1000 Index by only 0.1% annualized. Thus it does not seem like a great deal to be positioned in small caps.

Premium valuation
Taking valuations into consideration, there are disparities to address, as small caps currently command a premium valuation. In the year 2000, large-cap stocks traded at a forward price-to-earnings ratio of about 27 compared with 14 for small-cap stocks. Currently, however, the average forward P/E for large caps is around 15, while small caps trade at a multiple of about 19 times prospective earnings.

Some benefits
One good thing about the Russell 2000 ETF is that it has a much smoother distribution of assets. Thus it doesn't carry the risk that a few megacap stocks will have an outsized impact on the performance of the portfolio, as is often the case with large-cap index funds. For example, the top 10 holdings of the Russell 2000 account for just 3.3% of assets, compared with 18% for the S&P 500.

This extremely low company-specific risk makes even more sense when you analyze the weightings of the fund, as this ETF has larger weightings in business services, financials, technology, and consumer discretionary. As a consequence, it provides less exposure to the energy, media, and utility sectors, which have relatively large weightings and company concentration in large-cap indexes.

Final foolish thoughts
Although the Russell 2000 index covers 2,000 stocks, they only represent about 8% of the U.S. stock market. Therefore, theoretically speaking, small-cap stocks should constitute only a small part of a passive investor's portfolio. If your intention is to cover the majority of the U.S. stock market with minimal overlap, the best option would be to hold both the Russell 2000 ETF and the Russell 1000 ETF.

If your bet is that small caps will perform better, then you should give small caps an outsize weighting via a larger position in the Russell 2000 fund. Otherwise, an efficient way to control your capitalization exposure is to buy a total-market fund like the iShares Russell 3000 Index (NYSEMKT: IWV  ) and then use a smaller position in the small-cap fund for tactical purposes.

Bear in mind that small-cap stocks tend to be riskier, as they exhibit greater sensitivity to macroeconomic risks. This is because they typically lack economic moats and/or sustainable competitive advantages. Moreover, the Russell 2000 also holds a sizable stake in micro-cap stocks, which tend to be even more volatile than small caps.

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