Small-Cap ETFs: Behind the 10-Year Run | ETF Trends

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.