Growth Investing: Seasonality Favors Small Cap ETFs

Seasonality is an anachronism that is derived from certain asset classes historical penchant for over or under performance during certain times of the year. While it doesn’t always hold true in every instance, there is typically a trend towards strength in the fourth quarter that acts as a tailwind for certain stocks.

Ryan Detrick recently detailed his thoughts on the market and noted that the next several months has shown a tendency to favor small cap outperformance. In his study of monthly returns between large-cap and small-cap indexes over the last 15 years, the months of December through February have favored the Russell 2000 Index.

Examining a chart of the SPDR S&P 500 ETF (SPY) versus the iShares Russell 2000 ETF (IWM) since the July 2015 high, it’s obvious that small cap stocks have underperformed during this recovery. SPY is knocking at the door of its previous all-time high, while IWM is still languishing 6% below its prior peak.

With this short-term lookback, it’s easy to fall prey to the notion that now is the time to be bullish on large cap stocks and avoid the flagging small cap arena. However, I think that a counterintuitive approach will likely serve you much better.

If you are looking to position your portfolio for a further extension of this rally, then small or mid-cap stocks may offer more attractive upside than a large-cap benchmark such as SPY. The seasonal data points towards small caps being a greater beneficiary from any type of “Santa Claus” rally effect over the next several months. In addition, portfolio managers that are under-invested from the summer correction may start to realize that small caps have greater technical potential from a relative price standpoint.

Choosing a Small Cap ETF

Most ETF investors default to IWM as their preferred small cap vehicle. After all, it is the biggest fund in this space with over $20 billion in assets, and the Russell 2000 Index is considered the most popular benchmark to track. However, I would point out that the broad-based iShares Core S&P Small Cap ETF (IJR) has actually had much better relative performance than IWM coming out of the hole in October.