Investing in small cap stocks tends to be more risky than large caps, but over the long course of history, small-cap stocks have outperformed their large cap peers -- and by a significant margin. And that makes sense: After all, it's easier for a small company to grow by leaps and bounds than it is for an already-large company.
Of course, that hasn't been the case for a while. In fact, we've just gone through an extraordinary period in which large cap stocks have outperformed small cap stocks for the second longest stretch since the 1930s.
However, one popular Wall Street analyst sees the tide turning. In fact, this analyst sees a potential 50% return for small caps in 2024, as the market rally broadens out and dirt cheap small caps "catch-up" in valuation to large caps as the economy improves.
While that may or may not happen, there's a good case to be made. And if the small-cap rally takes hold, here are three great exchange-traded funds (ETFs) to play it.
Why small caps have underperformed so much recently
In order to decipher why a small cap rally may be in store, it may be a good idea to understand why they've underperformed so badly over the past decade or so.
First, small caps tend to be seen as riskier. That makes sense, as smaller companies tend to have less-diversified businesses, and also tend to need more potential funding than large caps with more resources. Small caps are also seen as more economically sensitive, as they tend to get all of their revenue and earnings from within the U.S. in only one or two end markets.
As such, small-caps not only tend to borrow more money, but often do so at higher interest rates, and often at variable rates. In fact, roughly 30% of the debt of companies in the Russell 2000 small cap index is floating-rate, compared with only 6% in the S&P 500. That makes them highly intersest-rate sensitive.
So small caps tend to need a "goldilocks" scenario to outperform. Following the Financial Crisis of 2008, everyone appeared to be afraid of the next big downturn. The growth scares of 2016, 2018, Covid, and the 2022 downturn all caused significant angst in the market, but didn't result in recession -- or at least in case of the pandemic, not a "traditional" one. But the fear caused investors to abandon small-caps en masse. And even in the strong recovery after the pandemic, high inflation and rising interest rates once again caused trepidation over small cap sensitivity to interest rates.
The composition of small caps also likely played a part. The rise in stocks over the past decade has really been lead by the technology sector. But the Russell 2000 only has about a 17.2% weighting in technology. By comparison, the S&P 500 has over 30% of its weighting in technology stocks.
As investors have both chased the exciting technology-fueled growth in cloud, AI, and sought the safety of The Magnificent Seven, it's no wonder small caps have been left behind.
One final factor may be competition for dollars from large capital allocators. Many large pensions and endowments are eschewing public stocks in favor of private equity and venture capital these days. Those two investment vehicles tend to occupy the high-risk, higher-upside portion for these allocators' portfolios, which used to be occupied by small-cap stocks. As an example, the famed Yale endowment now has 40% of its funds in private investment vehicles, whereas in 1990 it had only 5%. So, that lack of demand for public small-cap stocks due to more fashionable private investments may be a contributing factor.
Why the tide may be turning for small caps
Why might small caps suddenly begin to outperform? For one thing, that's actually the norm, not the exception. In fact, there have really only been three stretches in market history when large caps greatly outperformed small caps like they have over the past 10 years.
However, looking at the big picture of the stock market from 1936 to 2023, small caps have actually outperformed large caps almost 70% of the time, and by three whole percentage points on an annualized basis.
Second, the prospect of a healthy economy but with lower-interest rates could be in the cards -- a so-called "soft landing." That's really the environment in which small-caps thrive. With a high concentration in industrials, financials, energy, and consumer cyclicals, when the economy does well -- but without exceedingly high interest rates -- so do small caps. While inflation has remained a tad stubborn and the prospects for rate cuts have been pushed out in time, most still believe the Federal Reserve will begin to cut rates sometime later this year.
Third, the valuation gap between large and small caps has widened to historic proportions. As of February, the Russell 2000 average traded at about 15.2 times this year's earnings estimates, a huge discount to the S&P's forward P/E ratio of 19.6. That's a 22.5% discount. And as of April, the Russell 2000 traded at just 1.4 times book value, the biggest discount to large caps since the 1990s internet boom.
Fourth, not only do small-caps trade at historic discounts to large caps, they're also potentially set for outsized growth. Fundstrat analyst Tom Lee noted recently that small caps have higher estimated sales and earnings growth in fiscal 2025 compared with large caps. And with multi-strategy clients holding decade-low allocations to small caps, he sees a setup akin to 1999.
How did small-caps do after the burst of the internet bubble? Between 1999 and 2011, the small-cap Russell 2000 index outperformed the S&P 500 index by a whopping 6.5 percentage points annually, more than doubling the S&P's performance over those 10 years! That's why Lee thinks when small caps begin to outperform, it could be violent, yielding as much as a 50% return in 2024.
Are small cap stocks set to outperform? Image source: Getty Images.
ETF #1: The iShares Russell 2000 ETF (IWM)
The easiest and most diversified way to play small caps is to invest in an index fund tracking the Russell 2000. The iShares Russell 2000 ETF (IWM 0.33%) offers that with a fairly low expense ratio of 0.19%.
There are no frills with this index fund, which is a type of ETF. The IWM merely tracks the 2000 smallest public companies above a certain threshold (leaving out microcaps) in a diversified manner.
One advantage of having this big of an index is that the index can capture big winners, when the lucky small cap stock becomes large. For instance, the largest positions in the index are currently AI darling Super Micro Computer and Bitcoin-focused company Microstrategy, which have seen their market caps balloon to $46 billion and $22 billion, respectively.
Not exactly "small!" However, in the June rebalancing of the Russell 2000, these stocks and others above $10 billion are likely to exit the index. So, while the Russell 2000 is good at capturing growth when tiny companies grow, the index will cut them when they get too big, limiting further gains.
ETF #2: iShares Core S&P Small-Cap ETF (IJR)
Another way to play small caps is to go even smaller than the Russell 2000, with the iShares Core S&P Small-Cap ETF (IJR 0.12%). This ETF tracks what is known as the S&P 600 index, which tends to focus on the lower-end of the Russell 2000, tracking smaller companies in that index while still filtering out the extremely low-value microcap stocks.
For instance, the current largest holding in the ETF is healthcare services company The Ensign Group (ENSG +0.62%), with just a $6.7 billion market cap. In addition, the ETF actually currently holds 2% in money market funds as a way to maintain liquidity to buy and sell stocks.
While the IJR's 15.9% total return has lagged behind the IWM's 19.5% return over the past year, the IJR has actually outperformed over the long-term, with a 10-year annualized return of 8.8% versus the IWM's 7.5%. Not only that, but the IWJ's expense ratio is just one-third of the IWM's, at just 0.06%. That rock-bottom expense ratio and long-term outperformance may make the IWJ a superior choice for those who want "true" small cap performance.
NYSEMKT: CALF
Key Data Points
ETF #3: Pacer US Small Cap Cash Cows 100 ETF (CALF)
For those looking for a more actively managed ETF that seeks to outperform, while also mitigating some of the weaknesses inherent to small caps, the Pacer US Small Cap Cash Cows 100 ETF (CALF 0.18%) looks like an excellent choice.
This ETF has actually been the top-performing small-cap ETF over the last five years, with an annualized return of 15.84%, more than double that of the Russell 2000. And that outperformance doesn't appear to be mere luck, but rather a result of the ETF's deliberate strategic filtering.
Pacer isn't exactly actively managed; in fact, it's a passive fund. However, the fund uses a rules-based methodology that is quite different from an index. CALF essentially attempts to whittle down the S&P 600 to the 100 stocks with the highest free cash flow yields as a percentage of enterprise value.The ETF then rebalances regularly, but instead of weighting the securities by market cap, it weights each holding according to free cash flow dollars over the past 12 months. And it caps any weighting at 2% on rebalancing.
This is a great methodology, as free cash flow is usually a more sound way to measure potential shareholder returns than net earnings. This is because free cash flow also takes into account capital expenditures. Moreover, enterprise value is a better way to measure the total worth of the company than market cap, because it accounts for debt. For instance, a company may have a very low P/E ratio based on market cap, but if the company in question is heavily indebted, it may not be as cheap as it seems.
And not only does this filtering process help mitigate some of the weaknesses of all small-caps -- that being a lack of profitability and the need to use debt -- but the ETF also has another risk-mitigating filter: It completely cuts out financial stocks.
This is important, as the Russell 2000 has a relatively high proportion of financial stocks. These smaller regional banks and real estate companies can look quite cheap, therefore making it through the filter, but may actually be very risky. Moreover, small-cap financials are extremely sensitive to interest rates, as we saw unfold in the regional bank crisis roughly one year ago.
So by eliminating financials – the ETF's highest weighting is in consumer cyclicals, at 31.1% -- the ETF has managed to cut out a sector that has negatively contributed to the performance of most small cap indexes over the past 10 years.
As of March 2024, the index has an average 12.2% free cash flow yield and a P/E ratio of just 10.6. Those are huge yields these companies can use for reinvestment in growth, share buybacks, or dividends.
These are very prudent filters to put on a small-cap ETF, so it's no wonder the ETF has been a top small-cap performer. While its expense ratio is a tad higher than the index funds at 0.59%, as they say, you get what you pay for.
