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By Michael Rawson, CFA

Those who sold stocks during or after the crash and were slow to reinvest as the market rallied might want to use the recent sell-off as a buying opportunity. Over the past year, taxable-bond funds have seen net inflows of about $330 billion while stock funds have lost $10 billion. This would suggest that investors are seeking the safety of bonds. But at the same time, small-cap funds have seen about $12 billion of inflows while large caps have seen about $45 billion in outflows. In this article, we argue that now is a good time to invest in large-cap stocks relative to small-cap stocks and make some suggestions about which exchange-traded funds to use.

Depending on how they are grouped, small-cap stocks make up only around 10% of the U.S. equities market. Thus, they should make up only a small portion of the equities allocation and an even smaller portion of the total portfolio once bonds are included. For example, U.S. small-cap equities make up just 8% of our Hands-Free Portfolio, a low-maintenance portfolio built entirely of ETFs designed for long-term investors. In this article, Christine Benz discusses how to conduct a midyear portfolio review, including the use of the Morningstar Asset Allocator tool.

Large-cap companies tend to have wider economic moats and greater exposure to faster-growing international markets, and they are more likely to get a lifeline from the federal government. Small-cap companies typically grow at faster rates and stand to benefit from the large cash balances of large-cap companies should merger and acquisition activity pick up. Because they often operate within niche business segments or have just one business line, small caps are less diversified and are more sensitive to economic uncertainty, which results in greater volatility. But with this greater volatility comes the expectation of higher returns. Over the past 10 years, small caps have had a standard deviation of return of 22.2%, compared with 16.6% for large caps. One way to interpret this number is that, in any given year, if we expect small caps to return 8%, there would be a 36% chance of losing money and a 21% chance of losing more than 10%.

Based on Morningstar indexes, over the past 10 years, large-cap stocks have lost 2.7% per year while small caps have gained 4.8% per year. This outperformance of small caps has caused them to look more expensive relative to large caps. On a price/earnings basis, small caps currently trade at about 15.6 times earnings while large caps trade at about 14.1 times earnings. Thus, small caps trade at about an 11% premium to large caps. This is wide by historical standards, as over the past 10 years, small caps have traded at a slight discount to large caps on average. In the midst of the tech bubble, large caps traded at a P/E of 31 times while small caps traded at 16 times. Part of the reason that small caps currently trade at a premium is that analysts expect them to have better earnings growth over the next three to five years. However, we feel that GDP growth is likely to disappoint, which will impact stocks with higher growth expectations more severely than stocks with more muted expectations.

Based on the thesis that small-cap stocks are expensive relative to large-cap stocks, risk-averse investors who are underweight stocks might want to put money into large-cap funds while investors who are overweight small-cap stocks might want to reallocate money away from small caps and into large caps. Aggressive or tactical investors might want to place a pairs trade, selling small-cap funds and buying large-cap funds.

As the most-liquid small-cap ETF, iShares Russell 2000 Index (NYSEARCA:IWM) charges an expense ratio of 0.24% and is ideal for shorting. The Russell 2000 covers the 2,000 smallest stocks after the largest 1,000. The Russell 2000 index is one of the most commonly cited indexes of small-cap stocks, and it is often used by portfolio managers because it allows them to quickly gain exposure to small caps without having to buy hundreds of individual securities. The iShares S&P SmallCap 600 Index (NYSEARCA:IJR) charges 0.20% and covers the 600 smallest stocks after the largest 900 (500 stocks from the S&P 500 Index and 400 from the S&P Midcap 400 Index). S&P uses more-stringent screening criteria than other index providers to exclude unprofitable companies from index inclusion. This has resulted in a slight quality and value tilt to the S&P, which is more noticeable with small-cap stocks. Vanguard Small Cap ETF (NYSEARCA:VB) follows a small-cap index from MSCI and covers the 1,750 smallest stocks after the first 750. Charging just 0.14%, VB is one of the lowest cost ways to gain access to the small-cap market. Among these three funds, IWM has the smallest average market cap at $803 million, followed by IJR at $932 million and $1,268 million for VB.

For the large-cap exposure, Vanguard Mega Cap 300 Index (NYSEARCA:MGC) charges just 0.13% and covers the 300 largest stocks in the United States. Both iShares S&P 500 Index (NYSEARCA:IVV) and SPDR S&P 500 (NYSEARCA:SPY) charge just 0.09% for exposure to the 500 largest U.S. stocks. IShares Russell 1000 Index (NYSEARCA:IWB) charges 0.15% and pairs well without any overlap with the Russell 2000 index, but with 1,000 stocks, it contains a large number of mid-cap names. For those who want to focus in on just the largest stocks, iShares S&P 100 Index (NYSEARCA:OEF) charges 0.20% for exposure to 100 of the largest companies from the S&P 500. For those who would rather gain all of their U.S. stock market exposure in one fund, rather than buying separate funds, Vanguard Total Stock Market ETF (NYSEARCA:VTI) charges just 0.07% to cover the vast majority of the market.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: A Large Cap / Small Cap ETF Pairs Play