Domestic small caps, as tracked by the iShares Russell 2000 ETF (NYSEARCA: IWM) have significantly underperformed larger stocks in the past three months. You can easily compare performance of that ETF versus the large-cap SPDR S&P 500 ETF Trust (NYSEARCA: SPY).

The former is down 4.80% year-to-date, while the latter has gained 5.49% during that time.

Could that situation change when the Federal Reserve hits the brakes on rate increases? 

According to a May 16 Bank of America research note, since 1989, after the last rate increase in a series, quality small cap performed the best in the following months. Bank of America categorizes a stock as “quality” by using factors such as return on equity, free cash flow, return on capital, and stocks with a positive forward price-to-earnings ratio. These are indicators of a company's financial strength and the efficiency with which it utilizes resources. 

Value Beats Growth

Bank of America also found that small-cap value outperformed small growth in those scenarios. Technical factors, such as a high one-month change in a stock’s 200-day moving average, also played a role in determining leadership. 

Is some asset-class rotation in the cards if and when the Fed pauses rate increases? 

According to research from derivatives marketplace CME Group, “Are S&P 600 & Russell 2000 Small Caps Due for a Rebound?”, small and mid-cap stocks underperformed sharply in March due to regional banking turmoil. 

CME also notes that small and mid-cap stocks historically outperform large during periods of economic turbulence, such as inflation, volatile interest rates, recession and early-stage recoveries.

While the broad financial sector struggled, the tech-lade Nasdaq 100, as tracked by the Invesco QQQ (NASDAQ: QQQ), advanced 9.32% in March and built on those gains in April and May. 

Returning to the idea of quality small caps, it’s worth noting that among the group of top earners that also boast strong recent price action, none hail from the financials sector. 

These leaders include: 

• Green Brick Partners Inc. (NASDAQ: GRBK)
• Tecnoglass Inc. (NASDAQ: TGLS)
• Crawford & Company (NYSE: CRD)
• PROG Holdings Inc. (NYSE: PRG)
• Dream Finders Homes Inc. (NASDAQ: DFH)
• Genie Energy Ltd. (NYSE: GNE)
• M/I Homes Inc. (NYSE: MHO)
• North American Construction Group Ltd. (NYSE: NOA)
• NVE Corporation (NASDAQ: NVEC)
• Sterling Infrastructure Inc. (NASDAQ: STRL)

Not exactly a batch of household names, but that’s exactly the point. Relying on familiar names can be a good strategy, particularly when turning to well-established defensive companies with a long history of increasing dividends. 

Unique Growth Opportunities

But diversifying with small caps is also important because these stocks offer unique growth opportunities that you may not find in larger, more established companies. Small stocks can, at times, return more than larger stocks.

They also have different risk and return characteristics compared to large caps, making them valuable for diversification purposes. Various types of asset classes respond differently to economic conditions or market inefficiencies. 

A perfect example of the latter situation is small stocks’ underperformance during the regional banking crisis. While large-cap techs rallied, the info tech sector only constitutes 12.36% of the small-cap Russell 2000 index. That means small caps were more sensitive to damage in the financial sector, which comprises 16.08% of the smaller index. 

Seek Higher Quality

One takeaway from Bank of America’s research is that higher quality, profitable small caps that generate strong free cash flow are typically among leaders once Fed rate hikes pause. 

This is a good reason to include broad diversification among your holdings. Investors who focused on large-cap growth stocks were rewarded handsomely in 2020 and 2021. But as investors saw in 2022, there’s bound to be sector and asset-class rotation at some point. 

An event like a pause in the Fed rate increases could be a catalyst for small-cap outperformance, but as Bank of America notes, even that could be limited to a select group of stocks.