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The end of a volatile first quarter is approaching, and many investors are likely asking: What do I invest in now?

As we look at the returns from the first few months of 2021, one trend has emerged. Small-cap stocks have led the pack so far, a reversal of what we saw through most of 2020’s market recovery.
Graph titled “Small caps have surged in 2021” depicts year-to-date returns for small-cap stocks (Russell 2000) vs. large-cap stocks (S&P 500) from January 1 through March 19. While they align for the first few days of January, small-cap stocks quickly rise to about 5-10% higher than large-cap stocks at a given time. The graph lines ending at about 10.5% (small-cap stocks) and 4.1% (large-cap stocks).

The Russell 2000 Index, a proxy for smaller companies, has gained more than 10% year-to-date, even after what could be its worst weekly loss since October. That’s more than double the tally logged by the S&P 500, which is the large-cap benchmark of many professional investors.

As many investors in individual stocks and exchange-traded funds (ETFs) know, the daily swings in individual names can be masked by the performance of a broader index. Many people reading this have likely owned names that gained or lost more than 10% in a single week during 2021, let alone the past three months.

Active vs. Passive Investing

To that end, there’s no one correct way to invest, but there are two main and often contrasting investment styles: active and passive.

Passive investors tend to favor ETFs and mutual funds. If they own individual stocks, they probably don’t even check the price each day. Rather, their goal is usually to find a basket of companies (often larger and more established) that can consistently grow earnings, in hopes of building wealth over the long run.

On the other hand, active investors generally see short-term volatility as an opportunity. They tend to pick individual investments (large or small) to buy, and price momentum is often a key driver.

Small-cap Spotlight

Even before the “Reddit revolution” emerged, active investors have long been drawn toward the realm of small-cap stocks.

One characteristic that smaller companies tend to share is increased volatility. In other words, these stocks are prone to go up more in good times and go down more in bad times.

The higher volatility in small-cap stocks can be due to a handful of factors, but it’s primarily because fewer eyes are watching. Professional investors and analysts generally don’t spend as much time with smaller companies, so short-term volatility can be heightened when the market reacts to news.

When looking at small-cap stocks, names often fall into three main categories:

  • Smaller versions of established companies. Everyone wants to be the next Apple, Tesla or JPMorgan Chase, so what’s better than trying to find a mini version currently flying under the radar?
  • Turnaround stories. Some small-cap stocks are more established names that are in the doghouse. See the frenzy that’s unfolded in GameStop over the past few months?
  • The next big thing. This is where investors swing for the fences, trying to guess where the next big trends (like alternative energy, biotechnology or digital) lie.

In all three categories, information is key. Having the time and ability to research and pick individual smaller companies can potentially lead to the type of outperformance we’ve seen in the first quarter of 2021.

Just like any investment, small-cap stocks carry fundamental risks as well. For one, their revenue is more likely to be concentrated with a handful of major customers. When a small company has a lot of debt on its balance sheet, it also generally has to pay a much higher interest rate than a larger firm.

Where do we go from here?

Are small-cap stocks the way to go in the second quarter and beyond, or is the recent pullback in this group a sign that their reign has ended?

One thing we do know is that a rising tide can lift all boats. Passive and active investors can both prosper, just like small- and large-cap stocks can simultaneously move higher. The U.S. economy is currently trending toward high, single-digit GDP growth in 2021 as COVID-19 vaccine distribution expands and we gradually emerge from the pandemic. That environment favors small-cap names, which tend to have a more domestic focus than larger multinational firms.

The rising tide is also being supported by actions of the Federal Reserve. Fed Chair Jerome Powell has often stated that inflation growth appears to be manageable and has pledged to keep short-term interest rates low for the next couple of years to ensure a post-pandemic job recovery.

At the same time, the next round of government stimulus is likely to include infrastructure investment on top of the trillions already directed toward individuals and small-business owners.

Low rates and direct government investment can support businesses of all shapes and sizes. However, valuation still matters. Let’s not forget that the S&P 500 is up 75% from the March 2020 lows, and it has yet to go through a 10% pullback since then. As a result, the current environment appears to be favorable for those active investors willing to roll up their sleeves and find pockets of value in individual stocks.

The Bottom Line

Again, there’s no right way to invest, and both small- and large-caps could flourish this year (although of course, there’s never a guarantee when it comes to the market). But there are opportunities in this market that we think are ripe for the stock picker.

With a robust U.S. economic recovery expected for 2021 and market valuations already near record levels, we believe the current environment suggests more upside potential for those with both the time and appetite to research and pick individual stocks in the small-cap space.

We’re taking next week off for Good Friday, but we’ll be back with our Q2 2021 Market Outlook on April 9.

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Speech bubble icon next to text "Expert Take" Headshot of Lule Demmissie

During her tenure as president of Ally Invest, Lule led Ally Invest Securities, Ally Invest Advisors and API business lines. She also authored several articles about the investing industry and investor behaviors. Lule has a passion for agile product development and an appreciation of design thinking in shaping user-centric experiences. An advocate for financial and retirement solutions that rely on a mix of digital and human guidance, Lule believes in empowering individuals, especially women and minorities, to independently drive their own financial futures.