Lately, it seems like everyone has focused on major milestones for the Dow Jones Industrials (DJINDICES:^DJI) and the S&P 500 (SNPINDEX:^GSPC), with the Dow soaring through 15,000 earlier this month for the first time ever, and the S&P following suit with its push through 1,600 near the beginning of May and its subsequent push to within a couple percentage points of 1,700. Yet one of the strongest signs of the health of the stock market rally comes from an index that most people never even think about: the Russell 2000 (RUSSELLINDICES:^RUT) index of small-cap stocks.
So far this week, the Russell 2000 has pushed through the 1,000 on an intraday basis both yesterday and today, although it hasn't been able to close above that level. The move is more impressive when you consider that during the market meltdown, small-cap stocks got hit even harder than large-cap stocks, with the Russell plunging from a high of 856 in July 2007 to 343 at its March 2009 low. The 1,000 mark would represent a near-triple for the Russell, well ahead of the still-impressive performance of the Dow and S&P.
What's supporting small caps?
One trend that has greatly supported small-cap stocks is the resurgence in merger and acquisition activity lately. When you consider what happens in a typical merger, shares of the target company tend to skyrocket as most acquirers offer a significant premium to the target company's prevailing stock price to entice investors to approve the deal and to avoid higher counterbids from rivals. Because large caps are usually doing the buying and small caps are often the targets, small-cap stocks have an upward bias during periods of high M&A activity.
The other reason small caps are attractive to investors is that they have a lot further to go in terms of revenue and profit growth than their larger counterparts. By the time a company reaches the large-cap ranks, it has often gotten past its initial hypergrowth period and has started to become a more mature company. Maturity brings its own benefits, including more substantial dividend income, but for maximum potential price appreciation, small caps are a fertile breeding ground for promising prospects.
How to get small-cap exposure
The simplest way to get broad small-cap exposure is through exchange-traded index funds. For instance, iShares Russell 2000 ETF (NYSEMKT:IWM) has a strong record of tracking the Russell 2000 index closely. Other ETFs, like the SPDR S&P 600 Small-Cap (NYSEMKT:SLY), use other popular small-cap indexes as their benchmarks.
Regardless of how you invest, though, small caps have historically offered better performance than large caps. Over the past decade, for instance, the difference is almost 2.5 percentage points annually, and for long-term investors, that level of outperformance really adds up over time.
Still, some analysts believe that after such a strong run, large caps are overdue to catch up. Moreover, as the 2008 plunge showed, small caps can be just as volatile on the downside, so you have to be comfortable with higher risk.
One obvious solution is to have a balanced portfolio that includes both large caps and small caps. So if you don't own any small-caps right now, it's worth the time to take a look now at the potential benefits of diversification and return potential that they can bring to your portfolio.