Why now is the time to look beyond the S&P 500

Tom Bailey explains why it may be a good time for investors to broaden their US exposure to small caps. 

If you use exchange-traded funds (ETFs), the chances are you have an ETF providing you with larger-company US stock exposure, probably through the flagship S&P 500 or the MSCI USA index.

These indices have served investors well over the past few years, with not even a global pandemic standing in the way of gains being made.

It may, however, be time for investors to consider adding smaller companies to their US passive exposure.

First, smaller companies (small caps) give greater sector diversification. The US market has become increasingly concentrated, with a handful of large tech stocks. Over 25% of the index is classified as “information technology”, while other big tech names such as Amazon (NASDAQ:AMZN) sit in other sectors.

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In contrast, smaller company indices have much less tech exposure and much more exposure to less popular sectors such as industrials, real estate and consumer discretionary.

That’s not to say small-cap indices have no tech. For example, information technology is still the largest weighing for the MSCI US Small Cap index. It is also a sizeable weighting for the Russell 2000 and the S&P 600, two other notable small-cap indices. However, all three indices have much higher weightings to industrials, real estate and consumer discretionary than the S&P 500.

As a result, an ETF tracking one of these indices could act as a good complementary holding alongside US large caps.

This brings us to why now could be a good time to broaden exposure - the economic outlook currently looks good for smaller companies.

The performance of smaller company shares tends to move in line with the outlook of the economy. Small companies have also been disproportionately impacted by the pandemic. With the US economy now picking back up, thanks to both vaccine hopes and increased fiscal spending, smaller company indices could be poised to gain. Indeed, that has already been happening since November.

On top of that, the economic outlook is good for the sector composition of smaller companies. Industrials, real estate and consumer discretionary are all known as “cyclical” stocks, meaning their fortunes rise and fall in line with the wider economy.

Which index to track?

A smaller company index could provide investors with sector diversification and exposure to the post-Covid economic recovery - or both. But which index is best for this?

For those convinced by the above investment case, it looks like the S&P 600 index offers the optimal exposure.

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Its largest weighting, at the end of 31 December 2020, was towards industrials at 17.5%. More importantly, though, the three cyclical sectors mentioned above (industrials, real estate and consumer discretionary) collectively account for 45% of the index.

In contrast, those three sectors compose 38% of the MSCI USA Small Cap index and just 34.5% of the Russell 2000 Index. Those are all sizeable enough weights, especially when compared to the S&P 500 (the three sectors compose 23.5% of the large cap index).

Of course, on the other hand, if the economic recovery thesis turns out to be wrong, the S&P 600 may end up performing worse than the other two. Investors should also be aware that small caps are generally considered more risky.

Which ETFs?

For those looking to track the S&P 600 index, the cheapest is the Invesco S&P SmallCap 600 ETF (LSE:USML), which charges 0.14%, while the iShares S&P SmallCap 600 ETF USD (LSE:IDP6) charges 0.4%.

The MSCI USA Small Cap index can be tracked by the iShares MSCI USA Small Cap ETF USD Acc GBP (LSE:CUS1) for a charge of 0.43%.

For the Russell 2000 index, the cheapest are the SPDR® Russell 2000 US Small Cap ETF GBP (LSE:R2SC) and the Xtrackers Russell 2000 ETF 1C GBP (LSE:XRSG), both of which charge 0.3%.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.