Where Small Caps Actually Beat Large Caps

U.S. investors are getting used to large-cap equities outperforming small-cap rivals. That wasn't often the case in bygone eras, but over it's been happening here for five straight years.

What Happened: Interestingly, that trend isn't applicable to all regions. In fact, it reverses in Europe, which is saying something because economies there have long lagged the U.S.

“Historically, the relative performance of the EuroSTOXX indices has been similar to that of the US indices. However, since mid-2015, European small caps have continued to outperform large caps, while US small caps have lagged,” according to BNP Paribas research.

Why It's Important: One way for investors to access this trend is with the WisdomTree Europe SmallCap Dividend Fund DFE, the only dividend exchange-traded fund dedicated to European small caps.

“Since June 2015, European small caps have outperformed large caps by 2.5% annualised, while US small caps have lagged large caps by 5.7%. The biggest contributors to this divergence were technology, financials, and consumer discretionary ex-internet retail,” notes BNP Paribas.

In order, financial services, consumer cyclical and technology stocks combine for 45% of the DES lineup and are the second through fourth-largest sector exposures in the ETF. Importantly, tech isn't the primary source of potential strength with DES.

“Notably for small-cap financials and real estate, Europe outperformed, but the US underperformed. This shows that there were other reasons than just tech for the US small-cap underperformance,” said BNP Paribas.

DES has a 6.63% weight to real estate stocks.

What Happened: Small caps on both sides of the Atlantic aren't sporting noticeably attractive valuations, suggesting discounts aren't going to be the catalyst to get investors in the door.

“Historically, small caps trade at a premium to large caps: about 25% higher in the US and 10% higher in Europe. Currently, the premium in the US is just 8%, suggesting small caps are cheap,” said BNP Paribas.But when we exclude the expensive tech large caps, the premium rises to 30%, matching the long-run average. Europe multiples are similar, so there is no obvious opportunity simply based on valuations.”

Specific to DFE, a source of allure is a 3.24% dividend yield, which is well excess of what investors earn with either the S&P 500 or the S&P SmallCap 600 Index.

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