Last week, U.S. equities had a roller-coaster ride as investors grappled with a sharp selloff in big-tech stocks, which led to a rotation into small-cap and value stocks. This significant shift from large-cap to small-cap stocks has been dubbed the “Great Rotation.”
Just a month ago, small-cap stocks were making headlines for their poor performance compared to their large-cap counterparts. The Russell 2000 Index of small-cap stocks had been stuck in a rut for years. Over the past decade, it has underperformed the S&P 500 by 103% and the Nasdaq 100 by an eye-watering 332%. This ten-year stretch of underperformance was one of the worst for small caps compared to large caps in a century. As we reached the midpoint of 2024, the Russell 2000 was barely positive for the year, while the S&P 500 had posted a 15% gain thanks to the stellar performance of the Magnificent Seven.
However, on July 11, small-cap stocks made a comeback after the June consumer price index (CPI) report indicated a further easing of inflation and raised hopes for a September Fed rate cut. This news sparked a major rotation into small-cap stocks, which benefit from lower interest rates due to their higher borrowing costs.
The Russell 2000 surged by 3.6% when the CPI numbers were released. Political developments over the following days also contributed, increasing market optimism for a more deregulatory environment in 2025, depending on the U.S. presidential election results. Since July 11, small-cap stocks have risen over 7%, while large-cap stocks have declined by 3%.
However, the momentum of this trend may hinge on the July Federal Open Market Committee (FOMC) meeting. Although the Fed is not expected to cut interest rates at this meeting, investors will watch closely for any hints about future rate cuts. Interest rate changes significantly impact different sectors of the economy, and small-cap companies, which rely more on business loans, are particularly sensitive to these shifts.
“People typically believe that when you get rate cuts, that benefits small caps in a couple of ways,” said Thomas Martin, senior portfolio manager at Globalt Investments. Lower interest rates can reduce operating expenses for small companies, boosting their earnings. Additionally, lower rates can stimulate the economy, increasing consumer spending.
If the Fed signals a mild economic slowdown, it could help curb inflation. However, a sharp slowdown might raise recession risks, especially for small-cap companies, which are more exposed to economic downturns than large-caps. Analysts warn that achieving a soft landing will be challenging, as small labor market and economy cracks could lead to more significant issues.
Investors are closely watching these developments, as worsening conditions could adversely affect small-cap stocks. Both the Fed and small-caps have been walking a tightrope toward a soft landing. Achieving this would be ideal, but it's a big "if."
Despite the uncertainty, we believe that an allocation to small-cap equities is still sensible today. After a particularly volatile week, the Russell 2000 has risen by 3.5%, while the S&P 500 dropped by 0.8%. Disappointing earnings from some of the mega-cap names may potentially widen the gap between these two benchmarks.
Moreover, investors have already begun shifting from mega-cap to small-cap stocks in anticipation of future rate cuts by the Federal Reserve, suggesting that small caps could gain even more traction when the Fed eventually lowers rates.
In light of this, let’s discuss the prospects of iShares Russell 2000 ETF (IWM) and iShares Core S&P Small-Cap ETF (IJR). These ETFs offer broad exposure to various dynamic and fast-growing economies and industries.
iShares Russell 2000 ETF (IWM)
Managed by BlackRock, Inc., IWM focuses on the small-cap segment and has assets under management (AUM) of $72.21 billion. The fund’s top holdings include Insmed Incorporated (INSM), which has a 0.43% weighting. FTAI Aviation Ltd. (FTAI) is next at 0.42%, followed by U.S. Dollar and Vaxcyte, Inc. (PCVX) at 0.35% and 0.34%, respectively.
It has a total of 1976 holdings, with its top 10 assets comprising 3.35% of its AUM. IWM’s expense ratio is 0.19%, lower than the category average of 0.59%. Over the past month, its fund inflows were $7.07 billion.
The fund pays an annual dividend of $2.65, translating to a 1.18% yield at the prevailing price level. Its dividend payouts have grown at an 11.6% CAGR over the past three years.
Over the past nine months, IWM has gained 35.1% to close the last trading session at $221.73. It has also gained 10.5% year-to-date. The fund’s NAV was $221.67 as of Jul 29, 2024.
iShares Core S&P Small-Cap ETF (IJR)
With $84.61 billion in AUM, IJR also focuses on small-cap stocks. Its top holdings include U.S. Dollar at 1.61%, ATI Inc. (ATI) at 0.63%, followed by The Ensign Group, Inc. (ENSG) and Mueller Industries, Inc. (MLI), at 0.62% and 0.61%, respectively. The ETF has 605 holdings, with its top 10 assets comprising 6.82% of its AUM.
The fund's expense ratio is 0.06%, lower than the category average of 0.59%. IJR fund inflows were $1.01 billion over the past month and $3.66 billion over the past year.
IJR pays an annual dividend of $1.45, which translates to a 1.23% yield at the current price level. Moreover, the fund’s dividend payouts have increased at CAGRs of 11.3% and 5.4% over the past three and five years, respectively.
IJR has gained 32.2% over the past nine months and 8.1% year-to-date to close the last trading session at $116.99. The fund’s NAV was $116.89 as of July 29, 2024.
