Small-cap ETFs see biggest outflow in 5 years in July: Why not to shun the segment

Small caps are again the spotlight, but not because they are outperforming. According to Refinitiv Lipper data as of August 4, investors have pulled $94.7 billion from U.S. small-cap funds since the start of the year, including $47.3 billion in July alone – the largest monthly outflow in 5 years. That figure also far exceeds the total for the second quarter, when withdrawals reached $30.3 billion, the highest quarterly outflow since 2020. Despite occasional rallies, small caps have trailed large caps by a wide margin. In the first seven months of the year, the S&P 500 rose about 6.5%, while the Russell 2000 fell roughly 1.0%.

Investors are well aware of the risks that come with investing in small-cap stocks and tend to exit the segment at the first signs of trouble. In early June, the Russell 2000 briefly outperformed the S&P 500, rising 5.4% for the month. That advance was short-lived, however, as capital outflows restarted and the index slipped back below key support levels.

In a July report, Wolfe Research noted that recent gains in the Russell 2000 were driven by the relative strength of cyclical sectors, such as industrials and financials, compared with defensive sectors like utilities and consumer staples. The cyclical/defensive ratio, which tracks this correlation, climbed to levels typically seen at local market highs before turning lower. This could signal an approaching pause in the small-cap rally. Still, Wolfe Research stressed that the longer-term uptrend remains intact, framing the move as a temporary shift in investor preference for more conservative assets.

As of August 1, the Russell 2000’s 12-month forward P/E ratio stood at 32.50, compared with 24.80 for the S&P 500 and 17.47 for the S&P SmallCap 600. While elevated forward multiples often deter investors, much of the Russell 2000’s current growth is driven by niche, little-known companies generating positive net income and stable free cash flow.

About 35% of Russell 2000 constituents are unprofitable, which dilutes aggregate earnings and inflates the P/E, according to BofA Global Research. Excluding these companies brings the projected P/E down to 15.5.

This underscores a key difference between the benchmarks: the Russell 2000 covers the full spectrum of small-cap stocks, while the S&P SmallCap 600 focuses primarily on profitable businesses (less than 10% are unprofitable, which explains the valuation gap.

According to CME FedWatch, which tracks market expectations for the fed funds rate, 95% of traders anticipate a 25-basis-point cut to 4.00-4.25% at the Fed’s September meeting. For small caps with floating-rate debt coming up for refinancing, such a move would ease interest expenses and support operating margins.

The new trade rules that took effect yesterday, August 7, will raise average U.S. import tariffs to 18.3%, the highest level since 1934. The increase will immediately affect the cost of importing semiconductors and a range of consumer goods, adding to cost pressures for small manufacturers and retailers. Thus far, investors have largely shrugged off the tariff news, betting the impact will be temporary and the economy will adapt quickly, Barron’s reported.

Still, early signs of an economic slowdown are emerging. The ISM nonmanufacturing PMI slipped to 50.1 points in July, while the nonmanufacturing employment index dropped to 46.4, pointing to a softer labor market. The manufacturing PMI also fell to 48.0. The downturn is particularly acute for small businesses, which tend to be more sensitive to demand weakness.

Despite expected Fed easing and investor confidence that the economy will quickly absorb the new tariffs, weak macro data could hold back small-cap stocks. That said, Jefferies points out in a note that each of the four previous rate-cut cycles was accompanied by a "regime change" that sees smaller companies perform better than megacap tech: data going back to 1990 show that the S&P 500 Equal Weighted Index outperformed the traditional market-cap weighted version of the benchmark when the Fed is reducing interest rates. Jefferies says "the time to start rotating out of large cap tech may finally be upon us."

Despite recent headwinds, small caps have historically delivered strong long-term returns. Current valuations for the Russell 2000 suggest an average annualized return of around 9% over the next decade, compared with just 1% for the large-cap Russell 1000, BofA Global Research estimated in a July 14 report.

However, the small-cap universe is far from homogeneous. The Russell 2000 spans sectors with widely varying quality and growth prospects. Financials, Consumer Staples, and Utilities lead the pack, while Health Care and Energy are the biggest underperformers.

Financials offer a combination of moderate valuations and positive analyst forecasts. Consumer Staples and Utilities are attractive for their stable cash flows and high dividend yields. Health Care, while trading at steep discounts, remains a higher-risk, less predictable segment. The core value in the small-cap space lies in profitable niche players with sustainable business models and low leverage.

The AI translation of this story was reviewed by a human editor.