How Small-Cap Stocks Might Affect Your Portfolio in 2022

Small-cap stocks outperformed large caps in 2020, but their performance has been lackluster this year.

While the small-cap Russell 2000 index generated an 20% return in 2020 and beat the S&P 500’s 16.3% return, the bulk of the gain occurred during the last months of 2020.

Small-cap performance was outstanding from Sept. 24, 2020 to March 15, 2021 as the S&P 600 — another small-cap index — gained 69%, or more than three times the return of large caps. Since March, small-cap stocks have leveled off, and future returns appear less promising.

“While 2020 was a banner year for small caps, this segment of the market has traded generally sideways for the better half of 2021,” says Mike Loewengart, managing director of investment strategy at E-Trade Financial, an Arlington, Virginia-based brokerage company.

At some point in 2021, investors realized that supply-side constraints and higher inflation “would lead to demand destruction and soften growth expectations,” says Anthony Chan, former chief economist at JPMorgan Chase & Co. Many investors are now penciling in U.S. real gross domestic product growth ranging from 5.25% to 5.5% instead of 6% or more growth.

“Not surprisingly, this has caused the Russell 2000 to underperform the S&P 500,” he says.

If you’re wondering if you should own small caps, here’s what to keep in mind:

— Stock market factors have shifted.

— How small caps perform during inflation.

— Small-cap stocks help diversify over the long term.

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Stock Market Factors Have Shifted

While the U.S. economic recovery is on an upswing, the ongoing pandemic, supply chain bottlenecks and labor shortages continue to affect profit margins. Small-cap stocks tend to be domestic companies, and economic or fiscal challenges facing the U.S. have a greater impact on the balance sheets of these companies compared to larger businesses.

“There have been a number of monkey wrenches that have threatened to disrupt a full recovery,” Loewengart says. “With prospects of slower growth, small caps could potentially see less robust returns, but that doesn’t mean they should be ignored.”

U.S. small caps have historically outperformed when investors expect economic growth to accelerate, and that explains “why the Russell 2000 did so well relative to the S&P 500 in 2020,” Chan says.

With U.S. real GDP growth going from a -3.4% in 2020 to expectations that it would grow by 6% or more in 2021, it was “easy for investors to become enamored with small stocks,” he says.

Small caps tend to be riskier and generate a bumpier ride for investors, Chan says. When U.S. real GDP growth prospects are declining, it is “generally not a good short-term bet to bet heavily on small caps,” he says.

In 2022, few investors expect U.S. real GDP to exceed 2021’s growth rate, Chan says.

“That suggests that the large caps will outperform small caps in 2022 as U.S. real GDP growth is likely to slow further to 3 to 3.25%,” he says.

How Small Caps Perform During Inflation

Rising interest rates and inflation affect the margins of all companies, but they also indicate a strong economy.

If investors expect the U.S. economy to outperform global trends, small stock exposure could prove to be beneficial, says Steve Sosnick, chief strategist for Interactive Brokers, a Greenwich, Connecticut-based brokerage firm.

The flip side is that small-cap stocks “tend to be more idiosyncratic and economically sensitive and thus riskier,” he says. “Bear in mind that the total market capitalization of the Russell 2000 is about $6.7 trillion compared to Apple’s $2.3 trillion market cap. That leaves small caps much more subject to significant inflows and outflows.”

Since small caps run the gamut of various industries and have less concentration in sectors like tech, low interest rates “sometimes coincide with weaker economies and inflation may or may not reflect strength in the economy,” Sosnick says. “After those caveats, since small stocks tend to be more economically sensitive, we can assert that small stocks do well when monetary policy is accommodative and do worse when there are external pressures upon the economy.”

[READ: Understand Inflation Before It’s Too Late.]

Using the monthly 10-year yields for the past 20 years, the average monthly return was 1.1% for the S&P SmallCap 600 and 1% for the Russell 2000 in months where interest rates were less than 2.1%, says Jodie Gunzberg, managing director of CoinDesk Indexes at TradeBlock. Both the S&P 500 and S&P MidCap 400 returned 1.1%.

Small-cap stocks respond more by how much growth could occur in the U.S. than by a particular interest rate environment, Chan says. If interest rates fall because the Federal Reserve decreases rates due to an impending economic slowdown, small caps tend to underperform, he says. However, after interest rates hit bottom and economic tailwinds turn positive, the outlook for small caps improves.

If inflation rises moderately along with improving economic growth, it will be a favorable environment for small-cap stocks, Chan says. Small caps are better insulated from global developments.

Small caps perform much better on average in months when inflation declines, with the S&P SmallCap 600 gaining 1.4% on average in months with decelerating inflation and 0.5% in months with accelerating inflation, Gunzberg says. The Russell 2000 returns are similar with 1.3% on average in months of decelerating inflation and 0.4% in months with accelerating inflation, she says.

Small-Cap Stocks Help Diversify Over the Long Term

Adding small caps to a portfolio provides diversification from larger players and also eases some international risk since they tend to be domestic companies, Loewengart says.

“But because of their size, small-cap names can be volatile, so understanding your risk tolerance is key,” he says.

Investing in exchange-traded funds can help eliminate single-stock risk since researching small caps can take a fair amount of research, Loewengart says. An ETF such as iShares Core S&P Small-Cap ETF (ticker: IJR) is a good option with its 0.06% expense ratio.

Small caps add balance to a portfolio, especially for investors who are heavily weighted in the most widely held large-cap names such as tech stocks, Sosnick says.

Small caps tend to provide higher growth potential in exchange for some additional risk, “which is why investing in a diversified fund makes sense,” says Todd Rosenbluth, head of ETF and mutual fund research at CFRA Research, a New York financial research company. “These are often less established companies with narrower revenue streams but often with the potential to succeed.”

[See: 7 Monthly Dividend Stocks With Large Yields]

Investors could place funds into the broadly diversified Vanguard Small-Cap ETF ( VB) to gain exposure to consumer discretionary, financials, health care, industrials and information technology stocks, he says. The ETF charges a modest 0.05% expense ratio and has more than 1,500 holdings.

Another option is the iShares U.S. Small Cap Value Factor ETF ( SVAL) that targets value stocks that have also incurred limited debt leverage and have “favorable sentiment,” Rosenbluth says.

“The fund is heavily weighted to financials and industrials that should benefit as the economy strengthens,” he says.

Over the long run, small caps tend to outperform large-cap stocks, so an individual with a 5 to 10-year investment horizon should be comfortable investing 10% to 20% of their portfolio in small-cap stocks, Chan says.

“As a result, having long-term exposure to (small caps) is a good investment decision,” he says.

More from U.S. News

Why Value Investing Should Be Part of Your Portfolio

How to Beat Inflation in 2021

6 Best High-Dividend Mutual Funds and ETFs

How Small-Cap Stocks Might Affect Your Portfolio in 2022 originally appeared on usnews.com

Update 10/12/21: This story was published at an earlier date and has been updated with new information.

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