Frustrated small-cap investors are turning to profitable companies as the bull market in large-cap stocks begins its third year. The S&P 500 bottomed two years ago in October 2022, and has since rallied 63%, reaching a historic high last week. But not so for the small-cap Russell 2000 index: It doesn’t bottom out until October 2023, and is just 35% below the bottom, still 9% shy of its historic high in November 2021. Including 2024 The S&P 500 has now outperformed the Russell 2000 in 12 of the past 15 years. .SPX .RUT 5Y Mountain S&P 500 vs. Russell 2000 in the past five years. In their discontent, small-cap enthusiasts turned to ETFs that excluded unprofitable companies altogether, and those funds were attracting inflows. Small cap investors are waiting. And wait some more. Academic research has long supported the idea that small companies outperform large companies over long periods of time, and that value stocks outperform growth issues. But it certainly hasn’t been that way for a very long time. The problem is how long? Including 2024, the S&P 500 has outperformed the small-cap Russell 2000 in 12 of the past 15 years. Going back 15 years, the S&P 500 ETF (SPY) is up 440% while the Russell 2000 ETF (IWM) is up 260%. Many blame the formation of the Russell 2000, which is too focused on biotech, most of which is unprofitable, and small-cap banks, which don’t get the ball rolling. Russell 2000 ETF (IWM) (largest holdings by sector) Financials 24.2% Health Technology 14.0% Technology Services 9.6% Product Manufacturing 7.1% Electronic Technology 7.0% Given this disappointing underperformance, it is not surprising that investors continue to believe that diversification is an important component. In economics. Any portfolio that does not want to completely abandon penny stocks, they are looking for alternatives to simply investing in small companies based on market cap. Profitability Propensity Judging by the recent influx of funds, many seem to have found some solace by including an additional factor: profitability propensity. This makes sense, since about 40% of Russell 2000 companies are unprofitable. If stocks truly represent a call for a future stream of cash flow, then including a profitability slope may actually make sense. The SPDR S&P Small Cap 600 ETF (SPSM) does just that: it examines profitability (positive GAAP earnings over the past 12 months and in the last quarter) and liquidity. The intended effect is to weed out less stable companies. State Street Global Advisors (SSGA), which manages the ETF, said in July that the SPSM had outperformed the Russell 2000 (which does not have an earnings overlay) by 2.2% on an annual basis in each of the past three years. Investors seem to have taken note. Outstanding shares of the ETF have more than doubled since the beginning of 2023, indicating strong demand from investors. Inflows into the iShares Russell 2000 (IWM) declined slightly in the same time period. A similar fund that also tracks the S&P SmallCap 600 Index is the iShares Core S&P Small-Cap ETF (IJR). Other small-cap funds with a profit bent have also seen strong inflows recently, including the US Small Cap Value ETF (DFAS) and the Avantis Small Cap Value ETF (AVUV). Note: Rob Harvey, vice president of ETFs, and Ben Slavin, global head of ETFs at BNY Mellon, will discuss small-cap investing in the ETF portion of the Halftime Report on Monday at 12:35 p.m. ET, and at 1:15 PM ET. On ETFedge.cnbc.com.
The large-cap bull market turns two years away, leaving small-cap stocks far behind
