What recent small cap rally says about risk

The money flow into small caps may not be a rotation from winning growth trades.

Dave Nadig, ETF journalist and financial futurist, sees investors “just buying, buying, buying.”

“What we’re seeing is a diversification trade,” he told CNBC’s “ETF Edge” this week. “We’re seeing flows into everything, and that to me means people are looking to get a little bit broader in their exposure which is smart in an election year.”

Nadig contends broadening exposure in portfolios helps absorb volatility in the months leading up to presidential elections.

“[Investors] are now, for the first time in ages, buying value, buying some of these defensive sectors, buying small caps. But they haven’t stopped buying the other things as well,” he said. “I think this is money coming in from that giant bucket of money markets that we know is sitting out there.”

When it comes to the small-cap trade, Nadig thinks it’s too early to determine whether the upside is sustainable.

“If we have a sustained rally in small caps, and by sustained, I mean, like we have two or three months where small caps of all varieties are clearly beating the pants off large caps, then I think you’ll see a ton of money chase that performance that always happens,” Nadig said.

“If what we’re seeing instead is just a re-diversification trade, I think you would expect this to sort of bobble along a little bit here for the rest of the year,” he added.

The Russell 2000, which tracks small caps, fell 0.6% on Friday. But it outperformed the Dow Industrial Average, the S&P 500 and the Nasdaq Composite. Plus, the Russell 2000 squeezed out a gain for the week — up almost 2%. The index is now up almost 8% over the past month. But it’s been largely flat since President Joe Biden took office in January 2021.