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Why Small Caps Are Better Than Large Caps

Though 2011 is still young, a very interesting trend has emerged: Small-cap stocks are underperforming large caps. The Russell 2000 Index is up slightly more than 1% for the year, compared with a gain of about 3% for the S&P 500 so far in 2011.

There are some out there who have surmised this divergence is a bearish sign. Analyst Anthony Mirhaydari noted that, according to his calculations, the divergence between the Dow Jones Industrial Average and Russell 2000 recently has been the largest since May 2009, “a move that marked the initiation of the first correction after a rally from the bear-market lows in March 2009.”

It’s no surprise many are sounding the alarm bells now that small caps are fading. A common theory put forth is that these companies find their small size both a blessing and a curse — they can ramp up production for exponential growth in good times, or they have no safety net when the bottom falls out. To some investors, the underperformance of small caps in the last few weeks is a canary in the coal mine for blue chips and the market in general.

After crunching some numbers, I don’t think the data supports those claims. In fact, a look at the data proves small caps don’t just outperform in good times — they outperform nearly all the time. Let’s take a look.

Small cap stocks win 92% of the time

I calculated the returns of both the S&P 500 and Russell 2000 index across the last three years. And for 33 of the past 36 months, an investor putting money into an index fund would have been better served by purchasing the small cap Russell index instead of the S&P.

small caps vs large cap stocks

First, the three outliers: If you bought into the S&P 500 on May 3, 2010 — the first trading day of the month — and held through the closing bell Friday, you would have returns of 6.7% versus a smaller 5.6% gain in the Russell 2000 for the same period. The only other two times have occurred in the last six weeks — the S&P is up 6.4% since Dec. 1, 2010, versus 4.1% for the Russell 2000. And as mentioned earlier, the S&P is outperforming the Russell for the first weeks of this year.

However, aside from these meager instances, every other month in the past three years shows better returns for small cap index to present day — and many times, remarkably so.

Consider the Russell 2000’s 110.3% gain since the bear market lows around March 1, 2009, compared with 83.1% for the S&P in the same period. Or take the gain of 6.0% in the Russell since May 2008, while the S&P 500 has suffered a loss of 8.9%. Or most recently, the 23.8% gains for the Russell 2000 since the beginning of the recent rally on Sept. 1, 2010, versus 18.8% for the S&P 500.

In short, whether the market is about to take a historic flop like it did in 2008, or if it’s poised for a historic run like it saw in 2009, over the long term you are better off buying into small-cap stocks.

Small caps better with bulls, no worse with bears

But what if you’re not into buy and hold? What if you think you’re smart enough to time market cycles perfectly?

Not surprisingly, if you play your cards perfectly you do better in small caps. For instance, if you jumped into the Russell 2000 index at the exact low on March 9, 2009, and rode the almost-constant rise in the markets until the April 23, 2010, before a severe correction, you’d have 116.6% profits. The S&P in the same period tallies just 79.9%.

But if you think small caps drop as sharply in bear markets as they rise in bull ones, think again. If you had the worst-possible timing and bought at the peak on May 19, 2008, and then sold at the low on March 9, 2009, you would be in the same shape regardless of whether you chose the S&P or Russell index as your benchmark. The S&P 500 lost 52.8% in that period, while the small-cap Russell 2000 is off 53.5% — only a tiny bit larger decline.

Considering the potential for a much bigger upside against a nearly exact downside, why would any investor own an S&P 500 index fund in their 401(k) if their administrator offers one benchmarked to the Russell 2000?

If you can’t pick individual winners, buy the Russell

So what does this mean for you as an investor? Well assuredly a keen trader can pick and choose some stocks in your portfolio that don’t fit into these broader trends. Some winners like Apple Inc. (NASDAQ: AAPL)  have put many small caps to shame lately, and Wall Street is littered with broken small-caps that seemed like a good idea at the time. Take data storage company Xyratex (NASDAQ: XRTX) is off about -20% in the last year despite a significant rally across nearly all tech stocks.

If you can pick the big winners and avoid the big losers, more power to you. But for the average investor looking for the diversification of an index fund or benchmarked ETF, forget about the S&P or Dow Jones. The past three years of data shows clearly that the small-cap Russell 2000 index is a much better bet than the blue chips.

Or to put it bluntly, sell your SPDR S&P 500 ETF (NYSE: SPY) and buy the iShares Russell 2000 Index ETF (NYSE: IWM). If you own the SPDR, just look at the Russell’s charts for yourself and very likely you’ll see the small-cap index has better returns. That’s true over the past year, three years and five years.

And judging by these numbers, the Russell 2000 index should continue to outperform the blue-chip indexes. So whether the market is truly seeing a correction or just a pause in the bull market shouldn’t matter — make the switch from large caps to small caps now.

Jeff Reeves is editor of . As of this writing, he did not own a position in any of the investments named here. Follow him on Twitter @JeffReevesIP.

Article printed from InvestorPlace Media,

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