One of the emerging trends we’re seeing in 2015 is the renewed strength in small-cap stocks.

While the S&P 500 index is just bumping along sideways, small-cap stocks have jumped higher by 5.6% year-to-date. Given the 1.9% rise in large caps, that means small caps are outperforming by 3.7%.

That’s a pretty decent performance differential over just six months. And it reverses last year’s trend, which saw large caps outperform.

small-caps-vs-large-caps

Small-cap funds are also seeing money come in while money exits large-cap funds, according to data from Morningstar.

So what’s the deal? Should investors still be looking at small caps? (Spoiler alert: I think investors should always be looking at small caps.)

The backdrop for small-cap stocks looks pretty good right now. But there are a few things investors need to be aware of.

First, there has historically been weakness in stocks – including small-cap stocks – following the Federal Reserve’s first rate hike. I wrote about this a few weeks ago.

On the positive side, part of the case for small caps is that they don’t suffer the foreign exchange challenges that many large companies with international exposure deal with. With less exposure to international sales – 19% of sales for small-cap stocks as compared to 28% of sales for large-cap stocks – small companies are less impacted by a strengthening U.S. dollar.

Another part of the attraction is a return to more normal levels of merger and acquisition activity. Though M&A activity fell by 6.3% in May, it’s still tracking at more normal levels than the dog days following the Great Recession. And aggregate spending is still high, with May marking a 100.1% increase in deal spending over April.

The market still seems to embrace the reality that low interest rates and healthy balance sheets, along with steady earnings growth, make many small companies attractive takeover targets.

One also has to consider superior earnings growth for small-cap stocks. Earnings per share in the S&P 600 small-cap index should grow by 13.2% this year and by 32.3% in 2016. Those EPS growth rates far outpace expectations for the large-cap S&P 500, which currently sit at 0.5% for 2015 and 12% for 2016.

Within those estimates there is certainly some noise that investors should be aware of, mainly due to the fall in oil prices. Small-cap energy sector earnings will probably turn negative this year, while large-cap energy earnings are likely to get cut in half.

But on the flip side, earnings growth in other sectors is extremely strong. For instance, small-cap health care should grow earnings by 20% this year and 40% next year, while small-cap information technology should grow EPS by 66% this year and 34% next year.

The bottom line is that small-cap stocks tend to outperform over the long term. So while investors should certainly be aware that small caps trade at 19 times forward earnings versus 16.6 for large caps, it’s important to understand that those valuations reflect a rapid decline in energy sector earnings.

How to Play the Small-Cap Growth Trend

As Morningstar’s data shows, investors are continuing to buy small-cap funds, and this is by far the easiest way to play the small-cap growth trend. Of course, not all small-cap funds are created equal. And you’ll be surprised to find that there are significant differences among even the most followed funds.

For instance, the Russell 2000 is widely heralded as the benchmark index for small-cap stocks. Data for the index goes all the way back to 1979 (the actual index itself began in 1984).

But the lesser followed S&P 600 small-cap index is, in many ways, the superior index. Although it only dates back to 1994, the S&P 600 still has 20 years of history to consider. And over that time this index has done better than the Russell 2000. Much better, in fact.

According to data from Index Fund Advisors, the S&P 600 delivered an annualized return of 11.05% between 1994 and 2013. By comparison, the Russell 2000 delivered an annualized return of just 9.27% over that same time period.

Assuming a $10,000 investment, that extra 1.8% of annual performance by the S&P 600 generates $3,284 over 10 years, and $17,654 more over 20 years. In total dollar terms, that theoretical difference is $81,353 versus $63,699.

There are many reasons why the S&P 600 tends to outperform. The main reason is that the Russell 2000 is just the 2,000 smallest stocks among the 3,000 largest stocks in the U.S. stock market. There is no fundamental screen layered in.

Also, the index is reconstituted each year, so there are trading events that are well telegraphed to the market. Both of these factors likely lead to weaker performance for the Russell 2000.

In contrast, the S&P 600 index has a profitability screen – companies must have posted four consecutive quarters of profits to be included. And there is no annual reconstitution, so traders can’t game the index. Additions and deletions are decided by a committee.

Since the beginning of 2010, the S&P 600 is up by 115% as compared to only 98% for the Russell 2000. In other words, in my mind there is virtually no reason to buy into the Russell 2000 when looking for small-cap exposure.

If you go the funds route, consider iShares ETFs that track the S&P 600 (they have a value, core or growth option). Most online brokerages offer them with zero commissions, so you can dollar-cost average in small amounts.

And of course there are many, many individual small-cap stocks that you can buy. I cover what I consider to be the best of the best in Game Changers, which you can learn more about here.  And I featured one of these opportunities last week when I wrote about U.S. Concrete (NASDAQ: USCR).

Ultimately, the rapid growth of small-cap earnings will lead to another period of outperformance for the asset class. And I think that’s what the market is starting to realize.

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Published by Wyatt Investment Research at