Small-cap ETFs saw record inflows last week: Why fund managers see opportunities in this ‘underloved’ segment of the market

Sign up here for our weekly ETF Wrap.

Megacap chip stocks at the heart of the artificial-intelligence frenzy continued their record run at the start of 2024, but there’s one corner of the market where investors also put their money to work: small-cap stocks. 

Exchange-traded funds tracking small-cap equities saw record inflows last week, according to strategists at BofA Global Research. 

“Small-cap ETF momentum continued [in the week to Friday], with inflows in 22 of the 23 past weeks, and largest weekly inflow in our data history since 2017,” a team of BofA equity strategists led by Jill Carey Hall, head of U.S. small- and midcap strategy, said in a client note viewed by MarketWatch on Wednesday. 

The surge in inflows was predominantly fueled by retail investors, Carey Hall said. It was also a significant shift as Wall Street has gradually climbed down the market-cap ladder and started to bet on a rebound for the small-cap stocks after a mostly lackluster 2023.

Specifically, some of the small-cap ETFs tracking the benchmark Russell 2000 index
RUT
or a group of selective stocks saw strong net inflows in the week to Wednesday, according to FactSet data.

The iShares Russell 2000 ETF
IWM
and the Vanguard Small-Cap ETF
VB
saw $831 million and $870 million, respectively, in net inflows in the week to Wednesday. They were among the five funds attracting the most capital among nearly 900 ETFs that MarketWatch tracked over the same period, according to FactSet data.

Despite the positive sentiment, positioning in small-caps remained light last week, and their valuations were still inexpensive compared with history, Carey Hall and her team wrote. 

The laggard performance of small-caps throughout 2023 made this segment of the stock market relatively cheap, with the forward price-to-earnings ratio for the S&P Small Cap 600 index
SML
hovering at around 12.33 as of Thursday, compared with 18.16 of the large-cap benchmark S&P 500
SPX,
according to FactSet data.

Will Nasgovitz, chief executive officer at Heartland Advisors and portfolio manager of small- and midcap value funds at Heartland Funds, said the S&P 600 trading at a 30% discount relative to the S&P 500 speaks to “a very attractive valuation setup” for this “underloved and undervalued asset class,” he told MarketWatch via phone.

Typically, public companies trading at market capitalizations between around $250 million and $2 billion are defined as small-cap stocks. These companies with growth potential may deliver outsized returns when the economy is growing but could be extremely volatile when riding the interest-rate roller coaster as investors struggle to accept the reality that the Federal Reserve likely won’t cut policy rates anytime soon.

That’s why the record weekly flow into small-caps is no guarantee or indication of a strong performance for this long-suffering segment of the stock market. The Russell 2000 on Tuesday booked its eighth straight session with a move of at least 1% in either direction, its longest such run since a 10-session streak that ended in March of last year. Yet the index has tumbled 1.1% so far this week, compared with a 1.7% advance for the Nasdaq Composite
COMP
and a 1.6% gain for the S&P 500 over the same period, per FactSet.

Perhaps the underperformance of small-caps shows that investors are still “sniffing out weakness in the broader economy,” Nasgovitz said, adding that investors might want to consider asset classes with lower risk-reward and “definitive self-help catalyst,” which could help their portfolios “discount” the weakness in the economy. 

See: Small-cap stocks haven’t been this volatile in nearly a year. What it means for the long-suffering segment.

Midcap stocks shouldn’t be ignored

Sal Esposito, head of ETFs at Zacks Investment Management, said his portfolio-management team for the Zacks Small/Mid Cap ETF
SMIZ
now “leans heavier” on companies situated in the middle of the market-capitalization range, with around 70% of the assets under management allocated to midcap equities and 30% to small-cap. 

“Traditionally, people view small-caps as more of a high-flying investment with wild swings in stock prices, but midcaps give you more exposure to companies that potentially stay more stable, bigger,” and that have more potential for growth, Esposito told MarketWatch in a phone interview on Wednesday. 

See: 20 midcap stocks with 2024 upside ranging up to 62%, according to analysts

Midcap stocks usually refer to companies with a valuation of between $2 and $10 billion, but they can often be overlooked. The S&P MidCap 400 index
MID
in 2023 lagged the S&P 500 by 10 percentage points and outperformed the small-cap S&P 600 by less than 1 percentage point, according to FactSet data.

Still, Esposito expects his team will adjust the SMIZ allocation to mid- and small-caps by the end of the year, when they get a “clearer picture” of the Fed’s interest-rate path, he said.

As usual, here’s your look at the top- and bottom-performing ETFs over the past week through Wednesday, according to FactSet data.

The good …

… and the bad

New ETFs

• Angel Oak Capital Advisors Tuesday converted two of its existing mutual funds into ETFs: the Angel Oak Mortgage-Backed Securities ETF
  MBS
  and the Angel Oak High Yield Opportunities ETF
  AOHY.
  MBS will be an actively managed, pure-play residential-mortgage-credit fund, while AOHY seeks to invest in higher-quality, high-yield corporate bonds and securitized credit assets, according to the firm’s press release.

Weekly ETF Reads