Frustrated small cap investors are turning to companies with profits as the bull market in big cap stocks starts its third year. The S & P 500 bottomed two years ago in October 2022 and since then has risen 63%, last week reaching an historic high. Not so with the small-cap Russell 2000 : it didn’t bottom until October 2023, and is only 35% off the low, still 9% shy of its historic high in November 2021. Including 2024, the S & P 500 has now outperformed the Russell 2000 in 12 of the past 15 years. .SPX .RUT 5Y mountain S & P 500 vs Russell 2000 in past five years. In exasperation, small cap enthusiasts have turned to ETFs that exclude unprofitable companies altogether, and those funds have been attracting inflows. Small cap investors wait. And wait some more. The academic research has long supported the notion that over long periods of time small caps outperform large caps, and value stocks outperform growth issues. But it certainly hasn’t worked out that way in a very long time. The problem is, how long is long? Including 2024, the S & P 500 has outperformed the small-cap Russell 2000 in 12 of the past 15 years. Going back 15 years, the S & P 500 ETF (SPY) is up 440% while the Russell 2000 ETF (IWM) is ahead 260%. Many blame the composition of the Russell 2000, which is heavily weighted toward biotechs, most of which are unprofitable, and small-cap banks, which aren’t exactly knocking the cover off the ball. Russell 2000 ETF (IWM) (largest holdings by sector) Financials 24.2% Health Technology 14.0% Technology Services 9.6% Producer Manufacturing 7.1% Electronic Technology 7.0% Given this frustrating underperformance, it’s little surprise investors who continue to believe diversification is an important component of any portfolio and are unwilling to completely give up on small caps are looking at alternatives to simply investing in small caps based on market capitalization. A profitability tilt Judging by the recent flow of funds, many seem to have found some solace by including an additional factor: a profitability tilt. This makes some sense, since about 40% of the Russell 2000 companies are unprofitabile. If stocks are indeed a call on a future stream of cash flow, then including a profitability tilt may indeed make sense. The SPDR S & P Small Cap 600 ETF (SPSM) does exactly that: it screens for profitability (positive GAAP earnings for the past 12 months and in the most recent quarter) and liquidity. The intended effect is to weed out less stable companies. State Street Global Advisors (SSGA), which runs the ETF, said in July that SPSM has outperformed the Russell 2000 (which does not have a profitability overlay) by 2.2% on an annualized basis in each of the past three years. Investors seem to have taken note. Shares outstanding in the ETF have more than doubled since the start of 2023, indicating strong investor demand. Flows into the iShares Russell 2000 (IWM) have been down slightly in that same time period. A similar fund that also tracks the S & P SmallCap 600 Index is the iShares Core S & P Small-Cap ETF (IJR). Other small cap funds with a profitability tilt have also seen strong inflows recently, including the Dimensional U.S. Small Cap ETF (DFAS) and the Avantis Small Cap Value ETF (AVUV). Note: Rob Harvey, Vice President of Dimensional Funds, and Ben Slavin, Global Head of ETFs for BNY Mellon, will dicuss small cap investing on the ETF portion of Halftime Report Monday at 12:35 PM ET, and at 1:15 PM ET on ETFEdge.cnbc.com.
