Small-cap investments spike amid diversification trend

Small-cap stocks have seen a notable increase in investments recently. This trend signals a diversification move among investors. Dave Nadig, an ETF journalist and financial futurist, believes this is a prudent strategy, especially in an election year.

In the past week we've seen the biggest short-term Small Cap outperformance in history.

Is this a signal of the long-awaited change in leadership?

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“What we’re seeing is a diversification trade,” Nadig said.

There are now about 3 times as many stock mutual funds and ETFs in the US as there are publicly traded equities.

Where have all the stocks gone?

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“Investors are now, for the first time in ages, buying value, defensive sectors, and small caps without abandoning other investments. This indicates people are looking to get broader exposure.” Nadig attributes this broadening to a significant pool of money in money markets.

On Monday, more than 50% of Russell 2000 stocks reached a 21-day high, a feat achieved only 24 times since 1979. Precedents that occurred when the small-cap index closed at a 2-year high, like now, resulted in a 100% win rate for the Russell 2000 and S&P 500. pic.twitter.com/YNGp3iZeWN

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He suggests that a part of this capital is now flowing into small caps, though the sustainability of this trend is yet to be seen.

Small-cap investments trend analysis

“If we have a sustained rally in small caps over two or three months, you’ll see a lot of money chasing that performance. However, if this is a re-diversification trade, it could result in moderate growth for the rest of the year,” he said. The Russell 2000 index, which tracks small caps, dropped 0.6% on Friday but ended the week with nearly a 2% gain. The index has risen almost 8% over the past month, although it has remained largely flat since President Joe Biden’s inauguration in January 2021. Anna Paglia, who develops global ETF strategies for State Street Global Advisors, noted that expectations of interest rate cuts could bolster sector laggards. She emphasized that while investors are becoming comfortable with risk, she does not anticipate a significant withdrawal from money market accounts since most of the money there is “sticky.” “Investors want to keep cash for specific reasons, and I don’t foresee a huge wave of reallocations to the stock market or ETFs from money market funds,” Paglia stated. This increased engagement with small-cap stocks could reflect a broader risk appetite among investors, though the longevity of this trend remains uncertain.