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iShares Russell 2000 Index (ETF) (IWM), Vanguard Small Cap ETF (VB), iShares S&P SmallCap 600 Index (ETF) (IJR): Do You Avoid Small Caps? Think Again!

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As the Fed’s “tapering”-induced uncertainty causes the markets to remain volatile, many investors are growing apprehensive of this year’s strong uptrend in equity prices. While some experts see the recent decline as the start of a downward reversal in the equity markets, others consider it no more than a breather that the market needs to continue its upward surge.

Whatever the market conditions, the majority of investors prefer the stability of large-cap stocks over mid caps and small caps. And why not! After all, large-cap stocks provide that extra level of security and “cushion,” which go a long way in helping investors to ride out phases of extreme stock market volatility.

iShares Russell 2000 Index (ETF) (IWM)Having said that, it’s important not to forget the contribution of mid- and small-cap stocks to overall market sentiment: They lead the overall market bias, be it bullish or bearish.

Small caps account for a big chunk of the total investable universe of stocks. Take, for example, two well-known, broad-based stock indexes: the S&P 500 (INDEXSP:.INX) and the Russell 2000 (INDEXRUSSELL:RUT). The S&P 500 is a large-cap index comprising 500 stocks. Its small-cap counterpart, the Russell 2000, consists of 2000 stocks from the small-cap space.

These sheer numbers, or “market breadth,” give small caps more influence on the direction of the overall equity markets than the large caps. Of course, fundamentally speaking, the large caps do most of the talking, because when it comes to revenue and earnings, they are comfortably ahead of the small caps. But by no means should this suggest that small caps are to be ignored.

Small caps are generally considered to be a better indicator of the domestic U.S.economy, as most of the small-cap companies have a massive domestic exposure. This is in contrast to their large-cap peers, which derive most of their revenue from overseas markets. So, in a way, if you’re bullish on the U.S.economic picture, you’re bullish on small caps as well!

But this can be a double-edged sword. I have already mentioned that small caps lead the bullish or bearish phase in the stock market. This means that these stocks will be the most vulnerable to any negative news on the economy. It is due to this extreme behavior that small caps are considered extremely volatile in nature and are shunned by most investors.

The following two charts focus on this risk-return characteristic of small caps versus large caps. The first chart depicts the historical volatility characteristics of three small-cap ETFs and one large-cap ETF over the course of four years. The volatility line depicts the 30-day rolling standard deviation of each of the ETFs. To simplify things, a higher volatility line signifies more risky behavior than a smaller one.

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