Why Small Cap ETFs Are Underperforming

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.

Investors Sticking Around Small-Caps

Whatever the reason for the lagging performance relative to large-caps, the reality is that investors haven’t been bailing out on small-cap ETFs yet, for the most part.

That could have something to do either with their faith in the outlook for the segment, or with a growing acknowledgment that ignoring small-caps, globally, is ignoring about 14% of the equity investable “opportunity” in a global scale, according to MSCI data.

IJR has now attracted $3.2 billion in fresh net assets year-to-date, while the Vanguard Small-Cap Index Fund (VB) has attracted $1.8 billion in net creations year-to-date. But IWM has faced $2.3 billion in net redemptions so far this year.

Outside of U.S. small-cap exposure, funds like the iShares MSCI EAFE Small-Cap ETF (SCZ) and the Vanguard FTSE All World (ex-US) Small Cap Index Fund (VSS) have also been net gainers, raking in about $350 million and $200 million in net inflows year-to-date, respectively.

Institutional Investors Taking Notice

Small-cap stocks haven’t typically been the realm of institutional investors, but MSCI research shows that is now changing due to four trends:

1. Small-caps historically earn a premium relative to large-caps, and that size premium is true not only in the U.S. but also globally, making domestic and international small-caps attractive.
    
2. They are good diversifiers in an all-cap portfolio. They react differently in different parts of the market cycle, and are less exposed to macro global events and more exposed to domestic events.
    
3. They represent about 14% of the all-cap global equity market, so not owning small-caps leaves a sizable gap in a total market allocation.
    
4. Often thought to be a good spot for active managers, the reality is that these managers have not delivered consistent outperformance in the small-cap segment. Investors today are finding that index-based market-cap-weighted small-cap strategies as well as factor-based strategies focused on size fit the bill nicely, and often at a very low cost.

In the ETF market, there are more than 100 small-cap ETFs, the biggest being IWM with $36.4 billion, and IJR with $29 billion.

But the universe is diverse, with ETFs offering exposure to U.S. small-caps, global, EAFE, emerging markets, value/growth and smart-beta small-cap portfolios, each unique in their approach to the size factor.

They can all be seen in our Small Cap ETF Channel.

Contact Cinthia Murphy at [email protected]