The Big Problems Plaguing Small Caps

The Big Problems Plaguing Small Caps

Despite issues, ETFs may have solutions for those wishing to invest in the beaten down segment.

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Reviewed by: etf.com Staff
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Edited by: Ron Day

When I presented to etf.com the idea of writing about issues in U.S. small caps, I was asked a reasonable question: will this article need to be published quickly, or can it wait a few days?  

My response: the problems with small cap stocks aren't going away any time soon, so there’s no rush. They will still be here this Friday, and likely many Fridays from now.

Since peaking in November 2021, the now-$60 billion iShares Russell 2000 Index Fund ETF (IWM) has lost 14%, while the SPDR S&P 500 Trust ETF (SPY) has gained 18%.  

This isn't your garden variety performance lag. Small cap stocks, at least at the index and ETF level, appear to be among the most vulnerable parts of the stock market. This is more than a passing phase.

It wasn’t always this way. From June of 2000, when small caps were as exciting a prospective investment one could find, IWM gave us a lot to like. It offered a chance to own a piece of many smaller firms that were breaking into existing and new industries. Emerging tech and biotech, innovative consumer brands were all part of the thrill.

Then, as now, there was always the prospect of seeing some of those smaller stocks elevate themselves into the S&P 500. Many of today’s giant stocks were once Russell 2000 members.  

But along the way, things changed, the market evolved, and small cap stocks became a forgotten asset class. And it could be a while before some investors remember them.  

What’s the big problem with small caps today? I think it's a combination of structural issues at the index level, investors’ shifting preferences for where high returns are pursued, and a modern economy where it seems everything ends up being the largest 10% versus the other 90%.

Zombie Apocalypse on Its Way to Small Cap Land?

Estimates say that 40% of the companies in IWM lose money. Many of those firms have a bigger issue than recent losses in their operations. They have debt coming due, a ton of it starting late this year and into 2025. That debt allowed these companies to operate with a low cost of capital, but now rates are much higher. 

That interest expense line item in the income statements of many small public companies means we could see a “zombie” company issue over the next few years. That’s the term many on Wall Street use to describe firms that are only still in business because they can borrow money to stay alive.

Just as important for the current market environment, the deck is stacked against small caps because a new generation of self-directed investors has come to know and love a set of behemoth stocks that make seemingly endless profits and collectively help us run our lives. We all know the names. And they are found in the Invesco QQQ Trust ETF (QQQ), not IWM and other small cap indexes.  

In fact, the Russell 1000 Index now covers about 93% of the total U.S. market capitalization. That means small caps, roughly the next 2,000 companies by size, make up only about 7% of U.S. stocks by weight. How much attention will investors give to 7% of the market? Not very much, it seems.

Small Cap ETF Investors Have Solutions

Perhaps the bright side for small cap stocks is the fact that ETFs exist that help investors profit from whatever happens to this once-admired asset class. There are inverse ETFs like the $181 million ProShares Short Russell 2000 ETF (RWM) and its 2x and 3x levered cousins, which aim to profit from a continued lag in the small cap space.

And IWM is not the only way to own small cap stocks. Over the decades, approximately 150 others can be easily identified using etf.com’s ETF screening tool. This market segment can be further filtered to isolate potentially stronger parts of the small cap world. And to that last point, non-U.S. small caps are another outlet for those seeking to diversify their large cap stock exposure.  

It's not over for small caps. And ETFs might be the way for investors to navigate their current rut and potential return to prominence.

Rob Isbitts' Wall Street career spans 5 decades and multiple roles, all dedicated to providing clarity to investors by busting classic myths and providing uncommon perspective. He did so as a fiduciary investment advisor, Chief Investment Officer and fund manager for 27 years before selling his practice in 2020. His efforts now focus exclusively on investment research, education and multimedia. He started ETFYourself and SungardenInvestment to provide straightforward commentary and access to his investment intellectual property for portfolio construction, stocks and ETFs. Originally from New Jersey, Rob and his wife Dana have 3 adult children and have lived in Weston, Florida for more than 25 years.