Why Small Cap ETFs Are Underperforming

March 17, 2017

Small-cap ETFs were all the rage in 2016, with some of the largest funds in the segment delivering roughly twice the gains of U.S. large-cap ETFs in one year. But so far in 2017, small-caps have done very little.

They’re lagging their large-cap counterparts significantly, and fostering at least a little hesitation among some investors as to what lies ahead for the stock market.

The move is somewhat surprising if you consider that market experts like Bob Doll, chief equity strategist for Nuveen Asset Management, called for outsized gains in small-cap stocks in 2017.

Doll said that a move to nationalism in the U.S. and increasingly across the globe; a pickup in inflation after years of talk of disinflation; a transition from monetary easing to fiscal stimulus; and a rise in volatility should all help reshape investment goals toward more risk, more volatility and total return—all good for small-cap stocks.

What Should’ve Helped, Didn’t

These trends, he said, along with earnings growth, an improving economy, and tax and regulation reform should all bode well for stocks, particularly small-cap. This year was to be another blockbuster year for small-cap ETFs.

But look at the performance of the two largest small-cap ETFs, the iShares Russell 2000 ETF (IWM) and the iShares Core S&P Small Cap ETF (IJR)—each tracking a different small cap index—relative to the SPDR S&P 500 (SPY) year-to-date: 

Chart courtesy of StockCharts.com

That lag, according to ConvergEx’s Nick Colas, could have “three perfectly reasonable explanations.”

First, it could be that small-caps are just waiting for large-caps to catch up. In 2016, IWM was up more than 21%, and IJR was up 26%, while SPY rallied only 12%. Maybe small-caps are just waiting for their larger-cap counterparts to reach them, he said.

Colas also said that small-caps are lagging notably because driving the S&P 500’s outsized gains this year are some of its largest names—Amazon, Google, Facebook. In other words, this has truly been a rally fueled by large-cap companies.

Finally, it could be due to sector weightings, which are very different between the S&P 500 and a small-cap index such as the S&P 600, he said: “Tech, industrials and consumer staples are all more than 500 basis points different in weighting” between the two benchmarks. That matters, because this year sector performance has been dispersed.


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