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Small Caps vs. Large Caps: Which Is the Better Bet Now?

Small Caps vs. Large Caps: Which Is the Better Bet Now?

It is the David and Goliath tale of the summer, and it could not only dominate the second half but possibly the year as well. While rising stocks and record highs have been front page news for most of the year, a recent burst of outperformance by small-cap stocks (^RUT)(IWM) has left the big guys (^GSPC)(SPY) in the dust, with many wondering exactly what is going on.

"July was spectacular for small cap stocks," says Nick Colas, chief market strategist at ConvergEx Group, in the attached video. "It really got a lot of money managers' attention."

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But before you go and interpret some grand conspiracy or shift in risk tolerance, Colas says there's something far less sinister at work; the structure of the indexes themselves.

"The S&P 500 is much more heavily weighted towards a handful of names," he says. "If you look at the S&P 500, the top five names are ten percent of the index. If you look at the Russell 2000, the top five names are less than one percent of the index."

With that in mind, Colas and many other investors are faced with a choice. Given that both indexes are still within two percent of their all-time highs, it is his belief that the recent trend favoring small caps will continue.

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"They (small caps) have a lot of advantages. They tend to have a little more risk. A little more beta. A little more juice," he says, adding that "they're also a little more domestic in focus, so a global slowdown doesn't really effect them as much, and small companies also tend to be a little more innovative."

Add it all up and you get a big win for little companies.

Unfortunately, that can cut both ways, since a good run by just a few of the biggest companies can skew performance in favor of the large caps. An increase in volatility and fear would also see large caps come back in favor, as would upticks in a few key sectors.

"What's interesting is that the IWM is only 5% energy, (but) the S&P 500 is 11% energy," he says, pointing out that the weighting discrepancy favors the S&P 500 when it comes consumer staples, defensives and industrials.

"Industrials are also interesting," he says, since they have a weighting at 14% in the Russell 2000 versus 11% in S&P 500.

Ultimately, Colas says, this type of big or small allocation call comes down to "personal risk tolerance" and the amount of time investors have to meet their goals.

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