There are plenty of reasons for investors to consider exchange-traded funds made up of smaller companies, according to some recent research from BofA, which also makes some recommendations on which funds to consider. Hint: small is also better than large when it comes to fees.
Among other things, the BofA analyst team, led by Jared Woodard, is mindful that U.S. economic growth is likely to surge over the next two years — its economists forecast 7% GDP growth in 2021 — which benefits small-cap profits and performance more than larger companies, in part thanks to their greater exposure to “pent-up services spending demand,” they write.
Smaller companies are also bigger beneficiaries of the Blue Wave of fiscal stimulus by Washington, and have historically performed better than large caps during the middle of the business cycle , which is where the BofA analysts reckon we are now. They’re more likely to benefit from a boost in capex spending, and their valuations are more attractive than those of large-caps, the analyst team wrote.
The analysts recommend the Vanguard Small-Cap Growth ETF /zigman2/quotes/201855114/composite VBK -2.14% , the Vanguard Small-Cap Value ETF /zigman2/quotes/203042913/composite VBR -2.34% and the Vanguard Russell 2000 ETF /zigman2/quotes/204924513/composite VTWO -2.36% , taking into account fundamentals, technicals and efficiency.
Those funds have much leaner expense ratios, of 0.07%, 0.07%, and 0.10%, respectively, than many peers, as well as tighter spreads.
BofA have one caveat when considering investing, however: “small caps have given up their year-to-date leadership, and we also recognize there may be some further near-term risk,” they write. “Our work suggests that small caps have outperformed large caps only ~40% of the time in April vs. >60% of the time in May and in June.”
Still, there’s been a flood of money flowing into small-cap ETFs recently, they write, “across all major client groups, but led by retail – who we find, per our recent GWIM survey, are increasingly bullish on the size segment, both medium- and longer-term. Meanwhile, active funds are still very underweight small caps: small caps have been a shrinking share of multi-cap fund holdings, and large cap active managers are underweight the smallest stocks vs. overweight mega caps.”
The chart above, from the BofA research note, shows that roughly $35 billion has flowed into small-cap funds, which includes ETFs and mutual funds. That’s dwarfed by the $100 billion or so of outflows since 2013, when small caps began their secular underperformance cycle.