The leadership of small-cap exchange traded funds illustrates the strength of the rally in U.S. stocks and investors’ improved appetite for risk.

ETFs tracking small companies such as iShares Russell 2000 (NYSEArca: IWM) have outperformed the S&P 500 by a wide margin so far in 2012. The small-cap ETF is up 10.1% so far this year, compared with a gain of 5.6% for the blue-chip index, according to Morningstar.

Small-cap stocks often lead during the early stages of a rally, and they generally see wider price swings than shares of large, more established companies.

“Small-cap stocks tend to be more volatile due to narrower economic moats and a greater sensitivity to macroeconomic risks, but with this greater volatility comes a higher beta and the expectation for higher returns,” Morningstar analyst Michael Rawson writes in a profile of the Russell 2000 ETF.

“Small caps have historically provided a slight return premium over large-cap stocks,” he added. “A substantial stake in micro-caps can help juice returns for this ETF if the market rallies and over the very long term.”

The chart below shows the price ratio of the Russell 2000 fund relative to SPDR S&P 500 ETF (NYSEArca: SPY) showing the outperformance of small-cap stocks so far in 2012.

Full disclosure: Tom Lydon’s clients own SPY.

The opinions and forecasts expressed herein are solely those of John Spence, 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.