Small-cap stocks were one of the strongest areas of the market in the first half of the year, but have recently seen much of those yearly gains erased.
Periods of strength in smaller firms typically emboldens growth investors, as smaller companies are traditionally leaders in bull markets. Nevertheless, the recent weakness is a concern that should be noted as significant divergences crop up throughout the broader market.
Let’s examine where we stand today and some potential scenarios that could develop when investing in small-cap exchange-traded funds.
The initial leadership in the benchmark iShares Russell 2000 ETF (IWM) was driven by strength in technology, health care and consumer discretionary stocks.
IWM led the large-cap oriented SPDR S&P 500 ETF (SPY) by 3.5% through the first six months of 2015, but surrendered those gains after sizable drops in July and August.
However, IWM recently breached its 200-day moving average on the downside and managed to claw back a portion of that drop. The small-cap ETF is now seated firmly near this long-term trend line and appears to be setting up for another big move.
As you can see on the chart below, the succession of lower lows and lower highs has created a stair-step pattern in IWM. Technical analysts would consider this to be a bearish sign that favors lower prices. Nevertheless, if IWM can move back to the green for August and recapture its 50-day moving average on the upside, much of this damage can be repaired.
The catalysts for this type of move will likely depend heavily on the breadth and sentiment throughout the broader stock market. The summer is historically a very volatile period for stocks (and therefore small-cap ETFs) that can lead to repositioning and a pullback in overall risk-taking. That coincides with the type of drop that we have already experienced in the small-cap segment vs. the relative lack of movement in large-cap stocks.
If the bulls can pull it together and mount another rally attempt, the momentum may ultimately shift back to small-cap ETFs that have farther to run to recapture their highs.
Selecting Your Small-Cap Exposure
While IWM may be the largest and most well-known small-cap index, I actually favor the iShares Core S&P Small-Cap ETF (IJR) or Vanguard Small-Cap ETF (VB) as core holdings.
Compared to IWM’s widely diversified nature, IJR and VB are based on narrower indices with fewer than 1,000 stocks. This varying methodology has helped produce a noticeable level of outperformance in these small-cap ETFs over a 5-year period.
The IJR and VB ETFs have minuscule expense ratios of 0.12% and 0.09%, respectively, compared with 0.20% for IWM. In addition, IJR and VB are listed on commission-free trading lists at brokerages such as Fidelity (FIS), TD Ameritrade (AMTD) and Vanguard. This makes IJR and VB cost-effective solutions for accessing instant exposure to the small-cap space.
For clients in my opportunistic growth portfolio, I currently have a 10% allocation to VB as a core holding. This asset allocation sits right in the middle of an equity market-cap sleeve that could range anywhere from 5% to 15%, depending on market conditions. If conditions deteriorate further, I may look to reduce that exposure as a function of risk management and capital preservation.
Conversely, if small-cap stocks are able to regain their momentum, we may be presented with an opportunity to add to this segment.
Bottom Line
A modest degree of small-cap exposure within the context of a diversified portfolio can boost your exposure to stocks with the potential for above-average growth. However, those same characteristics also make this group susceptible to higher volatility as well.
My advice is to avoid being overly predictive or one-sided in calling the direction of small-cap stocks. If you are worried about the potential for further declines, simply set a sell discipline or other risk management plan in place to avoid a significant selloff.
This will protect your capital, and still allow you to participate in the upside if conditions react favorably to a year-end rally.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. To get more investor insights from FMD Capital, visit their blog. Click here to download their latest special report, The Strategic Approach to Income Investing. Learn More: Why I love ETFs, And You Should Too.
