Exchange-traded funds (ETFs) continue to dominate U.S. financial markets, with 2024 shaping up to be a record year for inflows. However, while ETFs have attracted vast sums of capital, small-cap stocks remain out of favor with investors. Despite this trend, Rob Arnott, the founder of Research Affiliates, sees significant opportunity in these often-overlooked underdogs. As small-cap value stocks struggle, Arnott’s latest ETF launch is designed to capitalize on their potential resurgence.
Small-Cap Stocks Out of Favor in August
ETFs have enjoyed strong inflows throughout 2024, with August marking a particularly robust month. According to a State Street Global Advisors report, U.S.-listed ETFs saw a net inflow of $73 billion across various asset classes. Despite this, small-cap equity ETFs experienced notable outflows, shedding more than $1 billion in August alone. This brings total outflows for small-cap stocks to over $20 billion for the year. In contrast, large-cap equity ETFs attracted $223 billion in inflows through August, with $23 billion flowing into these funds during the same month.
Small-cap stocks, particularly those classified as value stocks, have lagged behind their larger peers in performance. Arnott, however, believes that many of these small-cap value stocks are undervalued, presenting an opportunity for patient investors. “Underdogs often come back and surprise to the upside,” Arnott explained in a recent interview. He emphasizes the potential for mean reversion, where stocks that have been “kicked out” of market-capitalization-weighted indexes may eventually recover and outperform.
Rob Arnott’s New ETF: Betting on the Underdogs
With this investment philosophy in mind, Arnott’s firm, Research Affiliates, is set to launch its first ETF, the Research Affiliates Deletions ETF, trading under the ticker symbol NIXT. Scheduled to begin trading on September 10, the ETF is designed to buy stocks that have been removed from market-capitalization indexes such as the top 500 or 1,000 U.S. companies. Arnott believes that these deleted stocks tend to fall in price during the removal process but may rebound over time as they are reintroduced into the indexes.
The Research Affiliates Deletions ETF aims to avoid “value traps” by applying a quality filter. This screen helps the fund avoid companies with poor profit margins or weak cash flows, focusing instead on those with stronger financials that are poised for recovery. The fund’s benchmark is the Russell 2000 Value Index (XX), which tracks U.S. small-cap value stocks.
While small-cap value stocks have struggled this year, the iShares Russell 2000 Value ETF (IWN), which tracks the Russell 2000 Value Index, has gained 4.2% year-to-date. However, this performance lags behind other benchmarks, such as the S&P 500 (SPX), which has climbed 15.6%, and the Russell 1000 (RUI), up 14.7%. Large-cap stocks have dominated ETF flows, driven by the excitement surrounding artificial intelligence and tech giants like Nvidia (NVDA) and Meta Platforms (META), both of which have seen substantial gains this year.
Growth vs. Value: The Battle for Investor Dollars
Although growth stocks have outperformed value stocks in 2024, ETFs focused on value stocks saw more inflows than their growth counterparts in August. However, over the last three months, value ETFs have underperformed, trailing the inflows into growth-focused ETFs. This divide reflects a broader trend where megacap growth stocks have captured most of the attention, driven by optimism in sectors like AI and technology.
Shares of the Invesco QQQ Trust Series I (QQQ), which tracks the growth-heavy Nasdaq-100 index, are up 12.6% so far this year. Meanwhile, the iShares Russell 1000 Growth ETF (IWF) has surged 16.8%, far outpacing the 11.6% gain of the iShares Russell 1000 Value ETF (IWD). This divergence between growth and value has left small-cap value stocks in the shadows, but Arnott remains confident that this trend could reverse, benefiting the stocks targeted by his new ETF.
ETF Industry on Track for Record Inflows
Despite the struggles of small-cap stocks, the overall ETF industry is thriving. August was historically a slow month for ETF inflows, averaging just $32 billion over the past five years. However, this August defied expectations, with U.S.-listed ETFs gathering more than double the historical average. In total, U.S.-listed ETFs have attracted $610 billion in 2024 through the first eight months of the year, putting the industry on pace for record annual inflows of $950 billion.
Much of the inflow momentum has been driven by bond ETFs, which saw strong demand in August. The State Street report noted that U.S. equity ETFs captured $38 billion of inflows in August, representing 103% of all equity flows. Investors have favored domestic equities over international markets, with emerging market ETFs, particularly those focused on China, experiencing significant outflows. However, some emerging markets, excluding China, have been growing in popularity, as evidenced by the $795 million of inflows into the iShares MSCI Emerging Markets ex China ETF (EMXC) in August.
Key Takeaways:
- Small-cap equity ETFs have faced significant outflows in 2024, losing over $20 billion year-to-date, while large-cap equity ETFs have gained $223 billion.
- Rob Arnott’s Research Affiliates Deletions ETF (NIXT) seeks to capitalize on underperforming small-cap value stocks removed from major indexes.
- Despite small-cap struggles, U.S.-listed ETFs are on pace for a record year, with $610 billion in inflows so far and a potential for $950 billion by year-end.
- Growth stocks, led by tech giants like Nvidia and Meta, have outperformed value stocks, drawing most of the capital into ETFs.
- Bond ETFs have played a significant role in August’s strong ETF flows, as investors seek safety amid uncertain market conditions.
Conclusion
While small-cap stocks may be out of favor in 2024, Rob Arnott’s belief in mean reversion offers a compelling case for investors seeking value in overlooked segments of the market. With his new ETF, NIXT, Arnott aims to capitalize on the rebound potential of small-cap value stocks that have been kicked out of major indexes. As ETFs continue to dominate inflows, investors should consider whether the “underdogs” of the market might be poised for a comeback. Despite the overwhelming focus on growth stocks and large-cap equities, small-cap stocks may surprise on the upside in the years to come.