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Small-cap exchange traded funds (ETFs) have rallied hard after financial downturn, but some observers note that this trajectory won’t last and it is only a matter of time before this asset class cools down.

The Russell 2000 Index is almost 2% shy of its record closing high, reports Jonathan Cheng for The Wall Street Journal. Meanwhile, the Dow Jones Industrial Average and the S&P 500 are still 13% and 16%, respectively, off their record highs.

The Russell 2000 has surged 143% from its March 2009 nadir, whereas the Dow has increased 89% and the S&P has gained 95%.

Based on price-to-earnings ratios, small companies currently have the widest premium over large-caps since 1979. The Russell 2000 is trading at 18 times its one-year forward projected earnings, which is around 1.3 times the P/E of the market’s largest 200 companies. Valuations have hovered around these levels in 1983 and 2007, and after both occurrences, small-caps started to underperform the mid- and large-cap asset classes.

Still, Bhupinder Singh, small-cap equity strategist at J.P. Morgan, argues that the Russell’s performance illustrates how small-caps were better equipped coming out of a rough economic patch, which shows that this market still has momentum. Mr. DeSanctis of BofA Merrill Lynch comments that small-caps may experience 19% earnings growth for the first quarter, as compared to the 13% to 15% of the S&P. The broad U.S. economic recovery could help small-caps maintain their growth.

Yet an ETF industry strategist this week recommended investors trim small-cap stocks to moderate risk in their equity portfolios. Small caps tend to be more volatile and “appear to be fairly expensive relative to larger companies,” he said.

Vanguard Small-Cap ETF (NYSEArca: VB)


  • iShares Russell 2000 Index Fund (NYSEArca: IWM)
  • Vanguard Small-Cap ETF (NYSEArca: VB)
  • iShares S&P SmallCap 600 (NYSEArca: IJR)

Max Chen contributed to this article.

Disclosure: Tom Lydon’s clients own VB.

Source: Are Small-Cap ETFs Overheating?