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Is It Time to Reconsider Small-Cap ETFs?

This article was originally published on ETFTrends.com.

U.S. small-capitalization stocks and related ETFs continue to lag behind their large-cap peers.

Year-to-date, the iShares Russell 2000 ETF (IWM) , which tracks the benchmark Russell 2000 Index of small-cap companies, increased 13.0% while the iShares Russell 1000 ETF (IWB) , which tracks the benchmark Russell 1000 Index of large-cap names, advanced 18.2%.

“While many factors impact size performance, sector exposures tell a big part of the story," Alec Young, FTSE Russell's managing director of global markets research, said in a note. "A detailed look at industry weights helps explain recent small-cap underperformance. It’s no secret technology has been strongly outperforming the financial sector as a flattening yield curve and unprecedented declines in interest rates squeeze bank profits. The small cap benchmark sports for a hefty 27% financial industry weight vs. only 21% for its large-cap counterpart. What’s more, large caps also have greater exposure to technology performance leadership with a 22% weight versus only 13% for the Russell 2000 Index."

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In a prolonged bull market with the economy entering the later phases of the business cycle, investors have turned to more growth oriented areas of the market, including technology names, to capture greater returns.

On the other hand, a shift in monetary policy out of the Federal Reserve, along with falling rates due to increased demand for safe-haven assets, has depressed yields on the end of the yield curve and diminished margins for many banks trying to turn a profit on loans.

However, Young argued that due to these extreme pressures in the market, more contrarian investors should reconsider the current status quo and even begin shifting into the underperforming small-cap segment.

"The financial sector has had a very strong correlation with the direction of US treasury yields for several years and has begun to perk up as rates have stabilized. As for technology, the sector’s valuation premium is now well above its historical average reflecting structural growth tailwinds that are now widely appreciated. All this means that it may be time to re-evaluate small cap allocations,” Young said.

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