Veriton Investment

Investors Pocket Gains From Bets on Risky Corner of Stock Market

(Bloomberg) -- One of the riskiest corners of the US stock market has been rallying hard for the last few weeks, but investors burned by small caps time and again over the past four years aren’t sitting on paper gains.

Going by fund flows at the biggest exchange traded fund that tracks the Russell 2000, investors are pocketing profits almost as rapidly as they accrue. Some $5.4 billion has been pulled from the iShares Russell 2000 ETF this year, while the index it tracks has soared to an all-time high.

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Small caps have underperformed larger companies since the pandemic, getting hammered in 2022’s bear market and failing to rebound as quickly in the broad bull run that followed. The group tends to outperform when the economy is soaring and interest rates are relatively low, as many are profitless and need to borrow to fund operations.

Only now, with the Federal Reserve lowering rates for the first time in a year and the economy on track for another quarter of growth north of 3%, do small-cap investors appear to be gaining some confidence that the cohort will keep up with its larger counterparts. Flows have been positive in September, but not nearly enough to offset the drawdown throughout the year.

Years of false dawns for the group have damaged investor confidence, said Bloomberg Intelligence’s Athanasios Psarofagis.

“Seems they might just be taking some money while they can because the outperformance never seems to last long over large caps,” said Psarofagis.

The Russell 2000 was the last of the major American equity indexes to reclaim an all-time high after the latest bear market, needing four years to manage the feat. During that time, the Nasdaq 100, powered by the artificial intelligence euphoria, had advanced about 50%, setting record after record.

Recently, small caps went on their longest run of weekly gains in almost five years, as investors expect more rate cuts to keep the economy humming. That’s combined to shift sentiment, according to Michael Bailey, director of research at Fulton Breakefield Broenniman.

“They have had sort of this double dose of positive news,” Bailey said.

Skittishness abounds, though, as risky assets from small caps to crypto and profitless tech firms, have started to look stretched and investors pocket gains.

“Unfortunately, the rate cuts will be slow and deliberate and the fundamental outlook for earnings remains challenged which is why investors are taking profits,” said Sameer Samana, head of global equities and real assets at Wells Fargo Investment Institute.

Ned Davis Research flagged that the Russell’s breakout hadn’t been matched by the S&P Small Cap 600 Index, which excludes some of the weakest names in the broader guage.

Meanwhile, Wells Fargo analysts led by Ohsung Kwon said the small-cap trade based around easing interest rates was “over,” and recommended a rotation back into the artificial-intelligence names.

For Bailey, the divergence between the gains of the Russell 2000 and the outflows in the ETF are “a bit surprising.”

“It could be a simple rotation, where investors frankly just got more optimistic on large caps and focused fund flows there at the expense of small,” Bailey speculates.

It may take “another several months, maybe take a year or more of small caps performing in line or even better than large caps” for traders to bring flows back to small caps, he said.

Some investors may be taking profits from one risky market corner and seeking fatter returns in even riskier areas, said Todd Stankiewicz, president and chief investment officer at SYKON Capital.

“They’re saying ‘OK, what can I put in there? What can I put in for the same volatility which may have a potential higher return?’” Stankiewicz said. People are starting to chase “risk buckets” such as crypto ETFs.

Stankiewicz added that investors are going to have to see that smaller companies are not going to be “crushed” by tariffs in order to generate lasting flows into ETFs that track the space.

“If we see an easier business environment, small cap companies can benefit exponentially better than the larger cap companies and that’s what starts to shift some of those flows,” Stankiewicz said.