Small-cap exchange traded funds (ETFs) have been doing very well for themselves compared to large-cap funds for much of the last decade. Despite the market’s volatility in the last few months, small-cap funds are among a select few still perched above their long-term trend lines.

Jeff D. Opdyke for The Wall Street Journal reports that the long-running trend has carried over into 2010. Major indexes are negative year-to-date while small-cap funds are up about 3%.

The big question is how long this will last. In the past, small-caps have outperformed large-caps over extended periods, like they did from 1974 to 1983. But in this current bull market, the Russell 2000, another small cap index, hasn’t seen a 20% decline relative to the large-cap Russell 1000 since April 17, 2000. [Are New Small-Cap ETFs Late to the Party?]

A few factors seem to be driving small cap stock performance this time around.

  • The first is the ultra low interest rate environment that gives small-cap companies better access to debt funding.
  • The second is the nature of small-cap companies- they are more nimble and better able to cut costs to strengthen balance sheets and boost earnings.
  • In addition, small-cap companies will benefit in relation to large-cap companies as the dollar strengthens, since large-cap companies generate a significant portion of their income overseas.
  • Also, the surge of investor money into small-cap funds (recent market events aside) increases liquidity and demand for small-cap stocks.

According to Opdyke, small-cap stocks usually do not perform well in rising interest rate environments. Thus, as a stronger economy pushes up interest rates, the small-cap bull run could finally come to a close. [The Case for Small-Cap ETFs.]

In light of that, Opdyke recommends keeping an eye on 10-year Treasury notes and corporate bonds. An upward move in yields should indicate that investors are anticipating a Fed interest rate hike.

For the time being, the Fed has indicated that it will keep interest rates low since inflation has yet to significantly increase. If you still think there is some upside to small cap stocks, Don Dion for TheStreet recommends the iShares Russell 2000 Index Fund (NYSEArca: IWM), iShares S&P 600 Index Fund (NYSEArca: IJR) and Vanguard Small Cap ETF (NYSEArca: VB).

For more stories on small-cap stocks, visit our small-cap category.

Sumin Kim contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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