The concept is straightforward: Smaller companies carry more risk, and the markets compensate that higher risk with higher long-run returns. It would be the reasoning behind owning something like the iShares Russell 2000 ETF (NYSEMKT: IWM) alongside a large-cap fund, such as the Vanguard S&P 500 ETF (NYSEMKT: VOO). There's just one problem.
With just a few exceptions, that small-cap premium hasn't materialized for at least 15 years. This Rare Signal Is Flashing Again. In 2009, a "Double Down" signal flashed for a little-known chipmaker called Nvidia.
For the first time in years, that same "Total Conviction" signal is flashing for a company 1/100th the size of Nvidia. Continue » The following chart shows small-cap stock performance relative to large-cap stocks over this time frame. If investors were earning a small-cap premium, you'd expect this trendline to be moving up.
Instead, it's been trending down for years. With this type of recent underperformance coupled with an anticipated acceleration in earnings, the opportunity in small-cap stocks could be huge. Since the Vanguard S&P 500 ETF launched in 2010, it has gained 830%, far surpassing the 490% return of the iShares Russell 2000 ETF.
There are a few reasons the small-cap premium has disappeared. Lower profitability: Roughly 40% of Russell 2000 components are currently unprofitable. More broadly, earnings growth for smaller companies was lower due to higher interest rates, which disproportionately affect debt-heavy small-cap stocks, and the emergence of mega-cap tech as an economic driver.
Rate sensitivity: Small caps are disproportionately affected by higher interest rates due to higher debt levels to fund operational needs. The U.S. economy went through two major rate-hiking cycles over the past decade. Passive fund flows favoring large caps: The growth of index investing, S&P 500 ETFs, and other cap-weighted products has disproportionately pushed a lot of investor capital into just a handful of stocks.
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