The Recent Small-Cap Boom and its Implications for Risk-Taking: An Analysis of the Wave of Buying

The money flow into small caps may not be a rotation from winning growth trades.

Dave Nadig, ETF journalist, and financial futurist, see investors “just buying, buying, buying.”

“What we’re seeing is a diversification trade,” he told CNBC’s “ETF Edge” this week. “We’re seeing flows into everything, and that to me means people are looking to get a little bit broader in their exposure which is smart in an election year.”

Nadig contends broadening exposure in portfolios helps absorb volatility in the months leading up to presidential elections.

“[Investors] are now, for the first time in ages, buying value, buying some of these defensive sectors, buying small caps. But they haven’t stopped buying the other things as well,” he said. “I think this is money coming in from that giant bucket of money markets that we know is sitting out there.”

When it comes to the small-cap trade, Nadig thinks it’s too early to determine whether the upside is sustainable.

“If we have a sustained rally in small caps, and by sustained, I mean, like we have two or three months where small caps of all varieties are clearly beating the pants off large caps, then I think you’ll see a ton of money chase that performance that always happens,” Nadig said.

“If what we’re seeing instead is just a re-diversification trade, I think you would expect this to sort of bobble along a little bit here for the rest of the year,” he added.

The Russell 2000, which tracks small caps, fell 0.6% on Friday. But it outperformed the Dow Industrial Average, the S&P 500 and the Nasdaq Composite. Plus, the Russell 2000 squeezed out a gain for the week — up almost 2%. The index is now up almost 8% over the past month. But it’s been largely flat since President Joe Biden took office in January 2021.

Anna Paglia, who develops global ETF strategies for State Street Global Advisors, sees expectations for interest rate cuts as a catalyst for strength in sector laggards.

“Investors are really getting comfortable with risk, and there will be momentum,” said Paglia, the firm’s chief business officer.

However, she doesn’t see investors tapping into their money market accounts because people want cash for a reason.

“Most of it is sticky. I don’t suspect this big wave coming out of cash,” Paglia said. “I don’t think that there will be this huge wave of investors coming out of money market funds and reallocating to the stock market or to ETFs.”