Small-Cap ETFs Are Rallying. Should You Jump In?

Small-cap stocks are flying like a reindeer that didn’t realize his big annual gig already ended. 

The iShares Russell 2000 ETF (IWM), which for decades was “the” name in small-cap investing, is up 16.8% during the past three months. That is not the highest move ever, but it is close. And since the small-cap rally started at the end of October, a month from now we could be looking at the history books.  

For instance, coming out of the financial crisis in the spring of 2009, IWM gained 54% in three months. It rose 44% coming out of the pandemic crash in 2020 and flew 33% higher when the all-clear signal finally sounded in 2003, after three straight years of negative stock market returns. 

Or it could crash during the first quarter of 2024 or return somewhere in between a feast and a famine. Small caps are notoriously volatile, but they have also been notorious laggards in recent years. That could be because of investor preferences for mega-cap stocks or because of the fading fundamental condition of the Russell 2000 Index. 

A concerning 40% of companies in IWM have negative earnings. That figure has been climbing steadily for 10 years, which has created lots of buzz about whether small-cap stocks should still be viewed as they once were, as a higher risk and higher reward proposition than other stock types. The risk is still there, but until recently, the return has been missing in action. 

Small-Cap ETFs 

That prompts the question: Are there better ways to invest in small-cap stocks than simply dropping one’s wealth into IWM like it is a given. When that exchange-traded fund made its debut in the year 2000, that was the only answer. But as the ETF industry has grown, so has the number of funds that don’t tempt the fate of an index loaded with unprofitable companies.  

The iShares Core S&P 600 Small-Cap ETF (IJR) might have been the source of some high fives at BlackRock in recent years, as the concerns about IWM have come to light. BlackRock maintains IWM, and it created IJR back in 2000. It is considered by many to be a higher quality version of the broad small-cap market, and its $76 billion asset base now exceeds IWM’s $62 billion. So, investors are voting with their dollars here. 

For those looking to invest in smaller U.S. stocks but own a more focused basket with a defined quality filter, there are many choices. Those include the $6 billion Pacer US Small Cap Cash Cows 100 ETF (CALF), which uses a cash flow-based analysis process to set and update its portfolio.  

All three of the ETFs mentioned here are up about the same amount during 2023, which implies that for now, investors just want small-cap stocks and are not being too discerning. 

That may change in 2024, which means that ETF investors must now look beyond simply “allocating to small caps” and truly focus their research on what variety of smaller stocks they really want to own via an ETF. The choices are there for those who do the work.