Small-Cap Dominance Is Anything But Tiny

In the first half of 2018, one of the most notable trends in the U.S. equity market was the dominance of small-cap stocks and related exchange traded funds over large-cap counterparts.

The iShares Core S&P Small-Cap ETF IJR, which tracks the widely followed S&P SmallCap 600 Index, is up 10.7 percent as of July 3, while S&P 500 tracking ETFs are higher by 2.4 percent. On a historical basis, it's rare for smaller stocks to top large-caps by such wide margins in the first six months of the year.

What Happened

The small-to-large-cap spread is the widest in eight years, since the first half of 2010, and it's driven by tariff and foreign trade policy concerns, according to S&P Dow Jones Indices.

“In the past four months, the smaller companies have outperformed larger companies by 10.1 percent, contributing to the fifth-biggest realized small-cap premium in the first half of any year in history.”

Trade tensions, among other factors, are contributing to elevated volatility for large-caps. Year-to-date, IJR's annualized volatility is 50 basis points below that of S&P 500 ETFs. IJR's three-year standard deviation of 13.76 percent is 346 basis points higher than the S&P 500.

Why It's Important

Investors are embracing small-caps as the asset classes outperforms. In the second quarter, IJR took in $3.39 billion in new money, a total surpassed by just three other ETFs.

“The smaller cap stocks are less sensitive to international relations generally from the higher percentage of revenue generated in the U.S., though they are still impacted by sector fundamentals and the percentage of exports of foreign output since the U.S. economy is largely driven by consumer spending,” said S&P Dow Jones Indices.

The industrial, financial services and technology sectors combine for over half of IJR's weight. On average, those sectors in the S&P SmallCap 600 generate 74 percent of their revenue in the U.S. In the S&P 500, those sectors depend on the U.S. for just over 60 percent of revenue on average.

What's Next

The strong dollar is helpful for small-caps, particularly industrials, due to the aforementioned domestic focus.

“The rising dollar increases the small-cap industrials 84 basis points on average for every 1-percent dollar increase, whereas the large-caps only rise 67 basis points for the same dollar move,” according to S&P.

“Also, for every 100-basis point rise in interest rates, the small-cap industrials have risen 8.6 percent on average versus just 4.8 percent for large-cap industrials.  The result has been a 10-percent small-cap premuim for the sector this year.”

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