Small cap ETFs could be on track for their first year of outperformance versus large caps for nearly a decade as interest rate cuts, broadening markets and earnings growth could boost their rally further in 2024.
The asset class had a strong end to the year, outperforming the ‘magnificent seven’ in Q4 2023 with the SPDR MSCI USA Small Cap Value Weighted UCITS ETF (USSC) returning 18.3% versus 15.1% for the group of tech giants.
However, many still believe the rally has further to go with macro tailwinds and historical economic factors firmly on their side.
“We believe the small-cap leadership that began in Q4 is far from over, and think that 2024 could be the first year that small beats large in almost a decade,” Jill Carey Hall, head of US small and mid-cap strategy at the Bank of America (BoA), said.
Alongside interest rate cuts, Hall noted the improving breadth of the US equity market and cheap valuations as key factors.
“Small caps have historically led following narrow markets and 2023 was a record-breaking year for bad breadth,” she said.
“Meanwhile, small caps are the only size segment that is still cheap and trade at a remarkable 25% historical discount to large caps.”
Stephan Kemper, chief investment strategist, team advisory desk at BNP Paribas Wealth Management, told ETF Stream there are reasons to be optimistic about small caps if you do not think the US is heading into a recession.
“In this goldilocks economic growth scenario, small caps have been too tempting to be ignored,” he added. “They are still cheap, both against their own history as well as against large caps.”
The speed of the rally in small caps at the end of last year highlights how quickly changing market sentiment can drive performance in the asset class.
Rob Starkey, multi-asset portfolio manager at Schroders Investment Solutions, argued small caps could be a good play for investors positioning for the next phase of the economic cycle.
“It is important to be mindful that investment performance can be hit by increasing the allocation to smaller companies too early, it is prudent to make sure you have a seat at the table to avoid missing out on small cap performance, which often arrives suddenly,” he said.
“We are starting to find some attractive opportunities among small caps, particularly in regions that have already experienced the pain of higher interest rates.”
Investors still underweight
Despite a strong end to 2023, Hall said she believes investors are still underweight small caps despite the improving sentiment.
“Client flows into small caps as a percentage of market cap were positive for the last two years, but much lesser than large-cap flows,” she said.
“Importantly, multi-cap fund managers remain persistently underweight small caps, with positioning up just slightly off of record lows as of Q4.”
Demand for small cap ETFs has jumped so far this year, with the iShares MSCI World Small Cap UCITS ETF (WSML) pulling in $120m, according to data from Bloomberg Intelligence.
They have also been diverse, with the SPDR MSCI Europe Small Cap UCITS ETF (SMC) and the iShares MSCI EM Small Cap UCITS ETF (IEMS) recording inflows of $94m and $93m, respectively.
Kemper added the “stars are aligning for small caps”, but the asset class remains “positive neutral” in his portfolios.
“The rally came on the back of a year of underperformance so it gives you a bit of a sense of how quickly these things can go once the economic message turns a little bit,” he said.
