ETF flows are telling a tale the market can’t avoid: investors are going for small caps. The iShares Russell 2000 ETF IWM has surged more than 10% since the beginning of August, almost twice the SPDR S&P 500 ETF Trust SPY or Vanguard S&P 500 ETF VOO over that same stretch. The action is a sign of increasing belief that the widely anticipated Federal Reserve rate cut will reduce the cost of financing and release growth potential in smaller, debt-dependent firms.
The strategic rotation is appearing in fund inflows. One of the most liquid small-cap vehicles, IWM, has attracted new money. In the past month, IWM has pulled in around $2.3 billion in fund inflows, per FactSet. Interestingly, SPY has lost $6.6 billion in the past month. This underscores a desire to rotate into riskier areas of the market, hoping for a soft landing instead of a hard downturn.
Small caps have consistently trailed large caps each year since 2020, and long-term owners of IWM have lagged SPY. But the recent spike indicates momentum may be shifting. Experts anticipate the Russell 2000 may rise another 20% within the next twelve months, almost double the predicted gain for the S&P 500, based on Bloomberg data.
Nonetheless, Michael Wilson at Morgan Stanley referred to Fed easing as the probable “next leg” of the bull market, and moved small caps to neutral earlier this month. The qualifier: he needs to see more robust earnings revision breadth before turning more positive. To date, Q2 results have assisted. More than 60% of Russell 2000 firms topped expectations, with top-line expansion surprising by a mean of 130 basis points, per Bloomberg data.
For those who are seeking alternatives to IWM, many ETFs provide alternative flavors of small-cap exposure:
Vanguard Small-Cap ETF VB: Low-cost, broad access to 1,400+ small caps.
iShares Core S&P Small-Cap ETF IJR: Follows the SmallCap 600 with a quality bias, attractive to those concerned about lower-quality names in the Russell.
Avantis U.S. Small-Cap Value ETF AVUV: Has a tilt towards profitability and value factors, which is a good choice if rate cuts trigger a rotation into cyclicals.
For the time being, IWM’s beating SPY and VOO in gains since August is a strong indication that ETF investors are setting up for a more general bull market. If scheduled Fed cuts and earnings momentum materialize, small-cap funds could eventually end their decade-long losing streak to large-cap titans.
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Image created using artificial intelligence via Midjourney.