What's Ailing Small-Caps? A Sector Differential Solves The Mystery

Small-cap stocks and exchange traded funds are lagging their large-cap counterparts this. A comparison of the iShares Russell 2000 ETF IWM and the large-cap iShares Russell 1000 ETF IWB confirms as much.

What's Happened

Entering Wednesday, IWB was 17.2% year to date, outpacing the small-cap IWM by 510 basis points. However, the large/small gap has been particularly noticeable in recent months. Over the past 90 days, IWB is up 1.6% while IWM is lower by 2.7%, a chasm that's prompting some market observers to speculate that weakness in small-cap stocks is portending a broader market slump, or worse, a recession.

The small-cap slump is potentially more concerning when considering smaller companies are usually more domestically focused, meaning they offer some insulation from trade wars.

Why It's Important

As is to be expected, IWB and IWM have different sector exposures and the increasingly one-side rival between the two ETFs may be best explained by highlighting one of the most obvious sector differentials.

IWM's largest sector weight is financial services at nearly 18%, making the ETF vulnerable to declining net interest margins at the hands of lower interest rates. The large-cap IWB allocates less than 13% of its weight to financials, that ETF's third-largest sector exposure. IWB's top sector weight is technology at 22.27%.

“While many factors impact size performance, sector exposures tell a big part of the story. A detailed look at industry weights helps explain recent small-cap underperformance,” said FTSE Russell Managing Director Alec Young in a recent note.

“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.”

What's Next

While the sector weights in IWB and IWM aren't going to change dramatically anytime soon, the aforementioned points may be mostly baked into the funds.

“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,” said Young. “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.”

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