Small capitalization-weighted exchange traded funds underperformed their large-cap peers this year but could lead next year as the U.S. economy continues to expand.
The iShares Russell 2000 ETF (NYSEArca: IWM) has increased 0.4% year-to-date, while the S&P 500 index is up 10.5%. [Small-Cap ETFs Pick Up Speed Ahead Of Seasonally Strong Period]
Despite another strong year for the U.S. economy, small-capitalization stocks are falling behind after the overly optimistic bets in 2013 and a structural bias toward smaller stocks, reports Stephen Foley for Financial Times.
Going into 2014, many chased strong performance in small-cap strategies, driving up valuations, but Russell 2000 companies actually saw earnings fall last year. Consequently, valuations were stretched coming into 2014.
For instance, small-caps’ 12-month forward price-to-earnings multiple was at around 19.6 at the beginning of the year, or a 27% premium to the S&P 500, according to Neuberger Berman. Currently, IWM shows a 20.9 P/E, compared to the S&P 500’s 17.4 P/E, with the valuation premium now back in line with historical norms. Nevertheless, small-caps have historically traded higher than their larger counterparts.
Looking forward to 2015, the environment may look more favorable for small-cap stocks. Smaller companies have been increasing capital expenditures, which would allow them to capitalize off an expanding economy. Small-caps are also raising cash returns to shareholders. Additionally, small-capitalization stocks are more likely to benefit from merger and acquisition activity.
On the other hand, larger companies have to contend with decelerating growth in major overseas economies. Moreover, the companies do not benefit as much from falling prices of oil as compared to small-caps.
This year’s underperformance may also be just a minor blip in the small-cap’s long-term performance. According to Barclays, a $100 portfolio of small-caps in 1926 would be worth $1.4 million as of the end of 2012, whereas it would only be worth $200,000 if it were a large-cap portfolio.
iShares Russell 2000 ETF
For more information on small-capitalization stocks, visit our small-cap category.
Max Chen contributed to this article. Tom Lydon’s clients own shares of IWM.