How This Small-Cap ETF Can Play a Role in a Diversified Strategy

Outside a few brief stretches, small caps have consistently underperformed large caps for more than a decade. Fueled by low interest rates, trillions of dollars of stimulus payments, and a general dominance by megacap tech stocks, small caps had been unable to gain any consistent traction.

That has changed in 2026. A major market rotation away from tech has ignited a rebound in small caps from investors looking for better value and momentum. Many portfolios are and have been overweight artificial intelligence (AI) stocks and the "Magnificent Seven." This year, however, has shown that diversification still matters. Risk management still matters. And funds, such as the iShares Core S&P Small Cap ETF (NYSEMKT: IJR), may improve risk-adjusted returns over time.

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What is the iShares Core Small-Cap ETF?

Many exchange-traded funds (ETFs) carry the "small-cap" name, but their approaches can be very different. Within this category, the biggest differentiator could be whether the fund tracks the Russell 2000 or the S&P 600 (or, of course, a completely different index altogether).

This is important because those two indexes are significantly different. The Russell 2000 essentially captures the 2,000 largest stocks following the large-cap Russell-1000 index. There are few guardrails. Outside of some basic liquidity requirements, pretty much all stocks within that ranking range qualify.

The S&P 600 includes the stocks ranked by market cap following the S&P 500 and the mid-cap S&P 400 indexes. In other words, it's more broadly tilted toward larger companies than the Russell 2000. The other big difference is that the S&P 600 includes a quality screen. Qualifying stocks must have positive earnings in the most recent quarter and the past four quarters in aggregate.

In short, if you want broad small-cap coverage, the Russell 2000 is probably better. If you want quality small caps, the S&P 600 is probably better.

The iShares Core Small Cap ETF tracks the S&P 600. I feel having a quality screen in place for small caps is important. Roughly 40% of Russell 2000 components are unprofitable and prone to sharper pullbacks in the wrong environment. The S&P 600's quality focus helps mitigate some of that risk.

A different sector composition

The sector composition of small caps is also much different than what you see in the S&P 500. That makes it a good diversifier that can behave differently than large caps in various environments.

Currently, the S&P 600's largest sectors are financials (18%), industrials (18%), consumer discretionary (14%), technology (13%), and healthcare (11%). This index is much more cyclically sensitive, which means it could perform better when value stocks are in favor or the economy is accelerating.

As we've seen so far in 2026, there will be periods when tech stocks and megacaps underperform. Pairing those investments with a small-cap ETF whose portfolio and composition look much different can help balance out risk and reduce drawdowns.

Why small caps still matter

It's easy to ignore or want to stay away from areas of the market that have underperformed for long stretches. Up until the end of last year, such was the case for small caps, value stocks, dividend stocks, defensive equities, and bonds.

But there are always times when the pendulum swings in the other direction. Maintaining a balance reduces the need to try to time the market or pick winners, a strategy that usually ends up dragging down performance. Adding exposure to small caps, such as via the iShares Core Small Cap ETF, to a large-cap-heavy portfolio accomplishes that.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends iShares Core S&P Small-Cap ETF. The Motley Fool has a disclosure policy.