Skittish Investors Are Inching Away From Small Cap Funds?

U.S. small-cap funds went into full retreat mode in October, as investors began to brace for a market downturn.

According to Morningstar, small-cap value funds were down -2.06% over last month, and small-cap growth stocks fared worse, down 5.20% over the same time period.

Meanwhile, the iShares Russell 2000 Index Value ETF (IWN)  slid to $118.00 per share last week, down from $123 per share at the beginning of October. Additionally, the iShares Russell 2000 Growth ETF (IWO)  fell from $148 to $140, over the same time period.

As a result, money managers are picking up the pace in moving client cash away from small caps, even after many remained bullish on the sector only weeks ago.

On October 11, Fred Alger Management issued a survey of 200 financial advisors that concluded 76% were still "bullish" on small cash, even after a long period of underperformance.

"Advisors' optimism on U.S. small-cap equities comes at an interesting time, as these stocks underperformed U.S. large-cap equities by 15 percentage points over the past three years (as of 8/31/16), based on Russell indices," the report states. "Additionally, small-cap equities saw $14.7 billion of outflows over the past three years, compared with $122.3 billion flowing into U.S. large-cap stocks at the end of August 2016, according to Morningstar mutual fund and exchange traded fund data."

"Bullish sentiment from advisors toward U.S. small-cap stocks shows that they are confident in a performance reversal, thanks to both the undervaluation of the asset class and an improving U.S. economy," says Dan Chung, CEO at Alger. "With the understanding that such financial advisors are overwhelmingly optimistic on these equities, it will be interesting to see if their sentiment will translate into positive flows and greater valuations."

Some Wall Street professionals say that's just not going to happen.

"Small cap stocks are very expensive," says Jayme Wiggins, a financial advisor with Intrepid Capital Management, in Jacksonville Beach, Fla. "They're trading far above the housing bubble highs, and aggregate earnings for the Russell 2000 small cap index are actually negative right now. Consequently, My outlook for small caps is bleak - our portfolio is at DEFCON 1, right now.

Wiggins says his firm's advice for small cap investors is to pick your spots very carefully, since almost everything is overvalued. "Investors should de-risk their portfolios," he says. "If you aren't using a small cap fund that is positioned defensively, you should probably bail out now. This includes almost all passive small cap index funds and covers the majority of actively managed small cap funds. We don't know what 2017 will bring, but nearly all small caps are trading for more than can be justified by their underlying cash flows."

Ben Webb, a senior investment analyst and financial advisor at Balentine, a wealth management firm in Atlanta, agrees, saying he's seen small cap performance of the small cap "deteriorate" over the last month, especially as compared to larger stocks.

"The fund flow data we see confirms this," he notes. "We believe small cap stocks act as the marginal investment dollar for U.S. equity investors. Nascent fears of an equity market pullback will cause investors to seek safety in their large cap brethren. If you couple this with the disappointment small cap stocks have provided by underperforming large cap on a three-, 10- and even 20-year horizon, we believe investors are simply not seeing the risk/reward payoff in holding small stocks for the long term."

For ETF investors, Webb offers what he sees as a better option.

"For investors that would like to still have small cap exposure without a dedicated position, we believe holding a broad market ETF that invests in stocks of all sizes is a reasonable answer," he adds. "A perfect example of this is iShares Russell 3000 (IWV) . For a smaller fee, it gains the investor access to the top 3,000 stocks in the U.S."

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