Why Small Cap ETFs Poised To Pop

U.S. small cap ETFs have delivered a good run in 2019, but on a relative basis, they continue to underperform large caps this year even as the market makes new highs. This could be about to change, some say.

The recent relative weakness in small caps really kicked off in the last quarter of 2018 when the market took a downturn. Small-cap stocks are very sensitive to the domestic growth story, and concerns of a slowdown in the U.S. economy really took hold late last year, weighing on the segment.

The iShares Russell 2000 ETF (IWM) ended 2018 down 11%, tallying double the losses the large cap iShares Core S&P 500 ETF (IVV) saw last year. Year to date, IWM has recovered nicely, rallying 17%, but it’s still lagging IVV by about3%.

Eve Of A Rally?

In a recent blog, Anu Ganti, director of index investment strategy at S&P Dow Jones Indices, noted that tilting toward small caps has been a drag to overall equity returns, whether you are a broad stock investor or a factor-focused one. Betting on small size hasn’t really paid off relative to large caps.

It’s not surprising to see small cap ETFs lag large cap funds at this stage in the cycle. Smaller companies tend to do better in the early days of a cycle when growth expectations are at their highest.

Some, however, now say we could be at the eve of small cap ETFs’ next big pop.

Why? Because a more dovish Federal Reserve and possible interest rate cuts as early as this month could spark the next leg up of economic growth—the very scenario that would push small cap stocks higher.

“There’s a reversion to the mean argument, and small caps are usually hit hardest by market expectations,” said Sal Bruno, chief investment officer of ETF issuer IndexIQ. “Rate cuts by themselves are great for large cap stocks, as is a weakening dollar, but if economic growth starts to take hold and we see a steepening of the yield curve, small caps are big beneficiaries.”

Looking For A Catalyst

On paper, small caps are looking cheap, near historical lows relative to large caps, according to Ron Saba, senior portfolio manager at Horizon Investments, “so cheap they’re easy to neglect.”

Saba, who’s been a long-term small cap value investor, says investors are finding more attractive returns by buying mega cap stocks this year, technology names. They’ve had little reason to take a closer look at small cap ETFs.

But consider that the forward price-to-earnings (P/E) ratio of the Russell 2000 relative to the S&P 500 is close to its lowest level in 10 years, Saba says. The Russell 2000 forward P/E is about 20x and the S&P 500 is around 16x next year’s earnings.

Valuation Argument

According to Horizons’ data, small caps typically trade at 50-60% P/E premium on forward earnings to S&P 500 in a range that can go as high as 80%. Right now, we are at about 40% premium, on average.

“Small caps look interesting from a valuation standpoint; we just need some catalyst to turn sentiment around,” Saba said.

The market has already priced a rate cut later this month, but crucial for the small cap segment will be what happens next. Does the Fed remain supportive, and does the market believe in it enough to turn around the growth story?

“Second quarter earnings announcements are coming out soon, and expectations are for lower earnings and GDP [gross domestic product],” Saba noted. “If there’s any surprise to the upside, and we get better earnings in small caps relative to S&P 500—which will happen if we get a risk-on environment—it could be a double whammy.”

Assets Flowing In, Mostly

There are 123 small cap ETFs commanding more than $210 billion in total assets today. Among the biggest U.S.-focused funds are a pair of iShares ETFs, the iShares Core S&P Small Cap ETF (IJR) and the iShares Russell 2000 ETF (IWM), which together have nearly $90 billion in combined assets. The Vanguard Small-Cap ETF (VB) has $25 billion.

Investors have been pouring money into small cap ETFs, but are showing a preference for the cheapest strategies with decent liquidity. IJR, for instance, has taken in $2.2 billion in net new money in 2019. IWM, on the other side, has bled $4.2 billion in net redemptions. IJR costs less than half IWM’s price tag: 0.07% versus 0.19% in expense ratio.

IWM is the liquidity maven in this segment, with average daily trading volume of about $2.7 billion, but IJR trades a solid $200 million on average every day.

Price AND Liquidity

The appetite for IJR has come even as the fund has underperformed IWM this year, and it could be because the fund offers ample liquidity at a competitive price.

IJR has underperformed other competing small cap ETFs, including the cheapest U.S. small cap ETF, the $8 billion Schwab U.S. Small-Cap ETF (SCHA), which costs 0.04%, and VB, which costs 0.05%.

SCHA and VB have also attracted assets this year, but not as much as IJR, even as they significantly outperformed IJR’s returns. Nearly $480 million and $400 million in net inflows, respectively, have flown into SCHA and VB year to date.

Much like we see in other pockets of the ETF universe, price matters a lot to most ETF investors, but so does liquidity.

Charts courtesy of StockCharts.com

Contact Cinthia Murphy at [email protected]