The best performing part of the market right now is micro-caps

As the stock market has moved to new highs in all the major indexes, investors have turned their interest to some strange, underperforming parts of the market. The latest example: micro-cap stocks.

The iShares Micro-Cap ETF (IWC) has been around for more than a decade but has attracted little interest — until recently. And with good reason: it owns the smallest of publicly traded companies, the bottom 1,000 of the small-cap benchmark Russell 2000 index and the remaining 1,000 or so stocks that are even smaller than those in the Russell 2000.

Not pink sheets, but the very bottom of publicly traded companies. We’re talking companies with typical market caps between $50 million and $300 million.

In the last one month, these micro-caps have notably outperformed the broader market, and are again at a historic high Thursday:

What’s going on?

“You have a confluence of the reflation trade, rising rates and the tax cut trade,” said Martin Small, U.S. head of iShares at BlackRock. “All these things are positive for small- and micro-cap stocks.”

All true, particularly the rotation from large caps to small caps, but there may be other factors helping out:

1. Index inclusion: With the markets lifting across the board, many of these micro-caps have a good chance of graduating into small-cap indexes like the Russell 2000, which would drive wider ownership.
2. Composition of the fund: According to iShares, the fund is 25 percent weighted to financials, 25 percent to health care, two of the hottest spaces recently. I can see momentum traders adding this to their broader stake to get a small edge in performance.
3. The ETF wrapper: I’ve written about this many times. One of the things the growth of ETFs has enabled has been the ability to invest in areas of the market that were previously largely uninvestable, and micro-cap stocks certainly qualify. Think about the transaction costs involved in getting to some 1,500 or so stocks, not to mention the risk to the investor in trying to own even a small portion of these stocks. You couldn’t assemble this kind of portfolio easily until ETFs came along.

Putting it into an ETF wrapper — and allowing it to be traded on platforms provided by brokerage firms — is one of the only relatively safe ways to get into these darker corners of the market.

It also makes it easier for investment advisors to get exposure, Small tells me: “If you want micro-cap exposure, it’s irresponsible to do it other than through the index.”