After outperforming in September, the small-cap space is lagging again. In fact, the space is underperforming from a one-year look with the Russell 2000 Index — which tracks small-cap stocks – dropping more than 9%. The S&P 500 Index, meanwhile, is up slightly over the same time period (read: Small Caps Win in September: 5 Best ETFs & Stocks).
The beaten down prices coupled with a combination of factors seem a solid entry point for investors:
The one-year underperformance has brought small-cap valuations to their most attractive levels in years relative to large caps, presenting investors with a big buying opportunity for the long haul. Per an analyst at Jefferies, valuations for small-cap stocks are at their most attractive levels since June 2003 relative to large caps. Small caps have historically outperformed the large-cap brethren by an average of 6% over the following year when the valuation gap widens that much.
According to Bank of America Merrill Lynch, the relative P/E suggests that small caps should lead large caps over the next decade.
Small caps tend to outperform large-cap counterparts when the Fed cuts rates. The central bank has slashed interest rates two times this year to sustain a decade-long economic expansion. The speculation for a third rate cut is also ripe with market expectations for an October rate cut at 85%, according to the CME Group’s FedWatch tool (read: Chances of Fed Rate Cut in October Rise: Sector ETFs to Buy).
Lower interest rates bode well for the pint-sized stocks, perking up economic activities and resulting in higher spending, thus boosting domestically focused companies. According to Jefferies, small caps returned an average of 27.9% in 12 months after the Fed embarked on an easing cycle, while large caps gained an average of 15%.
Trade war has been playing foul on the large-cap stocks, benefiting the smaller ones, which are closely tied to the U.S. economy and do not have much exposure to the international market. This is especially true as the world’s largest economies have slapped tariffs on each other’s billions of dollar worth of goods over the past year, stoking fears of corporate earnings growth, especially for large-cap companies. Notably, large-cap companies have greater exposure to the international market and are vulnerable to tighter trade conditions (read: Low-Beta ETFs to Tap Amid Stock Market Selloff).
Additionally, lingering worries about Britain’s exit from the European Union, President Donald Trump’s impeachment inquiry and geopolitical tension continued to weigh on large-cap stocks.
The latest bout of upbeat data pointing to an increase in inflation, higher consumer and business confidence, retail sales, strong recovery in the U.S. housing market and solid manufacturing activity underscore the strength of the economy. The pint-sized stocks generally outperform in an improving American economy.
ETFs to Buy
While there are several options to play on the bullish trends, we have presented five small-cap ETFs that tend to gain more than their counterparts given their superior methodology. All these funds have a Zacks ETF Rank #2 (Buy), suggesting their outperformance in the coming months (see: all the Small Cap ETFs here).
Vanguard Small-Cap ETF (VB - Free Report)
The fund follows the CRSP US Small Cap Index and holds a basket of 1398 stocks with none holding more than 0.4% of assets. Financials dominates the portfolio at 26.4%, followed by industrials (20.5%) and technology (12.7%). The ETF is popular with AUM of $24.3 billion and trades in solid average daily volume of about 486,000 shares. VB is one of the low-cost choices, charging just 5 bps in fees per year from investors. It has added 0.8% over the past year.
Schwab U.S. Small-Cap ETF (SCHA - Free Report)
This product offers exposure to the 1758 small-cap stocks and tracks the Dow Jones U.S. Small-Cap Total Stock Market Index. No single firm holds more than 0.3% of total fund assets. The product is widely spread across sectors with financials, information technology, industrials, health care and consumer discretionary having double-digit exposure each. The product has managed $8 billion in its asset base and sees solid volume of more than 376,000 shares a day. It has an expense ratio of 0.04% and has shed 2.8% in a year (read: Why Small Cap ETFs Are Rising).
Vanguard Russell 2000 ETF (VTWO - Free Report)
This fund tracks the Russell 2000 Index, holding 2036 stocks in its basket with none making up for more than 0.4% of the assets. From a sector look, financial services takes the largest share at 26.3% while healthcare, producer durables, consumer discretionary and technology also receive double-digit allocation each. The ETF has accumulated $1.4 billion in its asset base and trades in average daily volume of 126,000 shares. It charges 15 bps in annual fees and has lost 4.3% in a year.
iShares Core S&P Small-Cap ETF (IJR - Free Report)
This fund offers exposure to U.S. small-cap stocks and follows the S&P SmallCap 600 Index. It holds 602 stocks in its basket with none accounting for more than 0.6% of assets. Industrials, financials, information technology, consumer discretionary, and healthcare are the top five sectors with double-digit exposure each. The ETF has AUM of $42.4 billion and trades in average daily volume of 3.1 million shares. It charges investors 7 bps in annual fees and is down 5.7% over the past year.
SPDR S&P 600 Small Cap ETF (SLY - Free Report)
This fund tracks the S&P SmallCap 600 Index, holding 602 stocks in its portfolio. SLYG is also well diversified with none holding more than 0.6% of assets and industrials, financials, information technology, consumer discretionary and healthcare accounting for a double-digit allocation each. The ETF has been able to manage $1.2 billion in its asset base while trades in a lower volume of 57,000 shares a day on average. It charges 15 bps in annual fees and has lost 5.7% over the past year (read: 4 Sector ETFs Leading the Small-Cap Rally).
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