Small-cap ETFs are currently outperforming larger-cap peers, a shift from previous years dominated by mega-cap tech stocks. The iShares Russell 2000 ETF (IWM) has seen a significant 22% year-to-date gain, surpassing the SPDR S&P 500 ETF Trust (SPY) at 13% and the Invesco QQQ Trust (QQQ) at 17%. This performance is attributed to three Federal Reserve rate cuts that have eased the pressure of floating-rate debt on smaller companies, a problem that had previously crushed small-cap earnings.
Erin Gibbs, Chief Equity Strategist at SlateStone, suggests that small and mid-cap stocks offer a better risk-reward profile than the S&P 500. She highlights that small caps, which historically trade at a 30% premium due to higher growth, were previously trading at a 30% discount to the S&P 500. While the gap has narrowed, they still trade at about a 20% discount despite having 30% higher forecast growth for the next two years. Gibbs believes this could lead to another 20% of outperformance, provided the Fed doesn't implement drastic rate hikes.
The durability of this small-cap lead is supported by several factors. The punishment small caps faced was primarily a balance-sheet issue, which has largely resolved with rate relief. Smaller companies, sensitive to interest rate changes due to their floating-rate debt, have benefited from the Fed funds target sitting at 3.75%. Additionally, broader market participation, improving fundamentals, supportive valuations, and muted investor positioning suggest a sustained rally. The average small-cap sector return was 23% in the first half of the year, outperforming the average large-cap sector by 13.6%.
