This simple graphic tells you all that you really need to know about the breakdown of major stock indices in the US. If you have the S&P 500, you cover 75% of the total market capitalization but you are missing the small cap allocation. Adding the Russell 2000 will cover the small cap universe and will not overlap with the market caps of stock in the S&P 500. If you add the S&P mid-cap index, you cover the gap between the S&P 500 and the Russell 2000. All three can be traded through ETF's. Hence, the simplest way to cover the US equity markets is through a weighted three asset portfolios of ETF's.
Of course, there are broader market ETF's that can be employed to cover the market, but then an investors does not get to make any tilts between small and large cap portfolios. The difference between small and large cap performance is consistent with a number of factors. Small caps are more volatile and more sensitive to business cycle risks. Early in a recovery, small caps should outperform larger companies. Small caps are usually more highly levered and sensitive to rates. They will also be more sensitive to available credit. They will also be more sensitive to the innovation cycles. However, small caps will be dragged down by increasing costs of regulation. They do not have the same economies of scale as large firms. Small caps will have more domestic focus; consequently, if there is greater global growth the big names should do better.
These returns differences are significant enough to allow for some asset allocation tilts that are consistent with changes in the growth cycle. Simply put, if you are pro growth you should be pro small caps and provide a higher risk weighting.
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