The outperformance of small-cap ETFs such as iShares Russell 2000 (NYSEArca: IWM) is an encouraging sign for the rally as investors take on more risk.

“Strong bull markets tend to be characterized by leadership and outperformance in small-cap stocks as money grows more confident about the future and positions for higher risk with higher return potential,” writes Pension Partners chief investment strategist Michael Gayed at MarketWatch.

“Bull markets do not have to be led by small-cap stocks as evidenced by several years in the 1990s, but powerful moves can result when they are. Clearly the S&P 500 has been the big winner thus far in 2012 as money favored liquidity when taking equity risk, but that appears to be changing,” he added.

The small-cap fund IWM is up 11.2% year to date while the S&P 500 has gained 13.7%, according to Morningstar.

The strength in small-caps “means risk sentiment is improving as money grows more confident in less liquid names,” Gayed wrote.

The chart below shows the relative performance of IWM against SPDR S&P 500 ETF (NYSEArca: SPY). When the chart is rising, it means small-caps are outperforming large-caps.

Full disclosure: Tom Lydon’s clients own SPY and IWM.

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.