Small-Cap ETFs Face Magnificent Seven Pressure

Small-cap stocks are popular with investors, at least until they look at their returns over the past five years. 

Many of the larger ETFs in the U.S. small-cap sector have raked in assets during 2023. For instance, the SPDR S&P 600 Small Cap ETF (SPSM) has brought in more than $3.6 billion, doubling its asset base since the start of the year. 

And the Pacer U.S. Small Cap Cash Cows 100 ETF (CALF), the Avantis U.S. Small Cap Value ETF (AVUV), the Vanguard Small-Cap ETF (VB) and the iShares Core S&P Small-Cap ETF (IJR) have each gathered at least $1.8 billion in new dollars this year. 

The other thing they have in common is that most of them haven't made a profit this year. Those flows haven't translated to buying pressure that overwhelms selling pressure, which market technicians will tell you is ultimately what moves stock prices up. It has become a twist on the old expression. In this case, the smaller they are, the harder they fall. 

Small-Cap ETFs Lag 

Small caps are certainly not the only laggards to their mega-cap tech brethren this year. 

There are some signs that quality and momentum, two factors that have helped the Magnificent Seven giant stocks leave the rest of the market in the dust, are present here as well. CALF is up a solid 11.4% year to date, and a momentum-focused ETF, the Invesco S&P SmallCap Value With Momentum ETF (XSVM), recently climbed above breakeven, up 0.4% year to date.  

But the best way to sum up the state of small-cap investing, once considered the “alpha dog” of stock market fans, is twofold: 

1. The longtime leading benchmark for this asset class, iShares Russell 2000 ETF (IWM), is up only 3.2% annualized the past five years, versus 11% for the market capitalization-weighted S&P 500 and 8.5% for the equal-weighted S&P 500. Going back to a more specific but meaningful date, Feb. 19, 2020, the market top at the onset of the pandemic, IWM has produced a mere 1.4% annualized gain. That’s just below 1-3 month T-bills over that same stretch. 
2. There’s been a constant “small caps are cheap and due for a comeback” chant from some corners of the industry, but it hasn’t materialized yet. In that respect, small caps join value stocks and non-U.S. stocks in playing second fiddle to the leaders of the Nasdaq-100 index. 

But there are some signs of optimism, and the ETF industry may be the one with the keys to unlock the small-cap story.

The diverse group of small-cap ETFs now on the scene allows investors to do more than settle for the Russell 2000 Index, the one that is still the only option in corporate 401(k) plans and perhaps the only one that some retail investors think of when pondering smaller U.S. stocks. That’s an opportunity for both investment advisors and ETF product creators to get out the message. 

That messaging probably starts with what the Russell 2000 has become. It takes the Russell 3000 index and removes the 1,000 largest stocks. It doesn’t have the filters for profitability, dividend payments or cash flow that some of the newer ETFs in this market segment have. 

As such, in an era where smaller companies have piled up debt and now face a “refinancing cliff” while economic activity is slowing, a small-cap portfolio that simply follows a market-capitalization method is going to look more and more like a “junk stock index.”  

That should create some excellent long-term opportunities for well-screened and monitored slices of the small-cap business. And that’s exactly where the ETF industry seems to be going. As they say, try to be part of the solution.