Small & Midcap ETFs Overtaking Large Caps In 2016

2016 is turning out to be a breakout year for U.S. stocks. After a year of wild ups and downs that left the market trendless from mid-2015 through mid-2016, the major stock market indexes are hitting new highs again.

The S&P 500 jumped to more than 2,188 on Thursday, pushing the SPDR S&P 500 ETF (SPY) to a year-to-date gain of 8.4%. That's a nice return compared with last year, when SPY only gained 1.3%.

SPY, of course, tracks a big chunk of the U.S. stock market, but not all of it. Its focus on 500 of the largest companies in the U.S. "captures approximately 80% coverage of available market capitalization" in the country, according to Standard & Poor's.

By design, the S&P 500 is a large-cap index of U.S. stocks. Stocks must have a minimum market cap of $5.3 billion to be considered for selection in the index.

The S&P 500 completely neglects stocks of smaller companies in the country. In recent years, that's been an advantage for SPY and other ETFs tracking the venerable index. Large-caps outperformed their smaller counterparts in both 2014 and 2015.

Midcaps & Small-Caps Outpace Large-Caps

Perhaps that streak will end this year. While the S&P 500 is up handily in 2016, the S&P MidCap400 and the Russell 2000—two of the most popular indexes tracking smaller stocks—are doing even better.

The iShares Core S&P Mid-Cap ETF (IJH) gained 12.7% on a year-to-date basis through Aug. 11, while the iShares Russell 2000 ETF (IWM) rose by 9.3% in the same time frame.

YTD Returns For SPY, IJH, IWM

As the name suggests, the S&P MidCap 400 tracks midcap stocks. According to S&P's current methodology, that means companies with market caps of $1.4 billion to $5.9 billion are eligible for inclusion in the index.

Meanwhile, the Russell 2000 is a small-cap index, with a current market cap range of $133 million to $2.9 billion as of the last index reconstitution.

Reasons For Outperformance

There are several explanations for the better performance of smaller stocks this year.

For one, investors may be more confident in the outlook for the U.S. economy. In turn, they may be willing to take on more risk by buying smaller, volatile stocks.

In that same vein, a stronger U.S. economy relative to international economies gives a leg up to domestic small-cap firms compared with multinational large-cap firms with footprints all around the world.

A more stable junk bond market—which small companies often rely on for financing—may also be partly responsible for the outperformance in 2016.

Different Time Frame, Different Results

Of course, the performance of any group of stocks depends on the time frame in question. Different comparison periods can lead to very different results.

For example, in the last five years, SPY delivered a gain of 107% compared with 100% for IJH and 90% for IWM.

5-Year Performance For SPY, IJH, IWM

However, in the last 10-year span, IJH is leading the pack, with a return of 147%, beating SPY's 112% and IWM's 108%.

10-Year Performance For SPY, IJH, IWM

Going back 16 years to May 2000 (the inception date for IJH and IWM) reveals an even wider spread between IJH and the rest, with a gain of 317% for the midcap ETF, 230% for small-cap IWM and 115% for large-cap SPY.

(Incidentally, the year 2000 was the top of the market before the dot-come bubble burst, a time in which many large-cap tech stocks were considered to be extremely overvalued.)

Sector Composition Varies

Speaking of which, a large part of SPY's outperformance in the past two years can be attributed to technology. It's the largest sector in the S&P 500, with a 20.8% weighting, followed by financials at 15.8% and health care at 15%.

In contrast, financials are No. 1 for IJH and the S&P MidCap 400 at 26.7%, followed by technology at 17.2% and industrials at 13.6%.

Similarly, for IWM and the Russell 2000, financials lead at 25.8% of the index, followed by tech at 17.6% and industrials at 14%.

Sector composition is one of many factors that set apart large-caps from midcaps from small-caps. That, in addition to differences in overseas revenue exposure, valuations and other factors, are likely to drive the relative performance of the three cap sizes going forward.

Contact Sumit Roy at [email protected].