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Investors still backing small caps, despite Yellen

In her congressional testimony Tuesday, U.S. Federal Reserve chair Janet Yellen raised the alarm on the small-stock sector, warning that valuations on smaller tech companies appear "stretched."

Indeed, small-cap stocks on both sides of the Atlantic have confounded investors with their underperformance, delivering disappointing returns this year – in spite of being tipped to continue the stellar gains seen in 2013.

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Janet Yellen, chair of the U.S. Federal Reserve
Andrew Harrer | Bloomberg | Getty Images
Janet Yellen, chair of the U.S. Federal Reserve

In the U.S., the small-cap Russell 2000, "one of the most widely followed small cap indices out there" has been a "major disappointment" according to Nicholas Colas, chief market strategist at brokerage ConvergEx Group.

Year to date, the index is off 0.8 percent after volatile trading, by contrast the S&P 500 is up over 6 percent over the same period.

In Europe, UK's FTSE 250 has lost around 2 percent so far this year, compared to 28.8 percent gains seen in 2013, which doubled the 14 percent gains seen in the large cap FTSE 100 last year.

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However, looking ahead to the second half of the year, fund managers are now positioning for gains in smaller companies,

Pricey valuations?

When compared with their previous performance, small caps are expensive according to data from Russell Indexes. The Russell 2000 was trading at nearly 20 times expected earnings for 2015 at the end of June, compared to the 15.8 average over the last five years.

Fund flow data also paints a mixed picture. Small cap inflows have swung from net inflows to outflows from week to week, according to figures from Lipper, the mutual fund data provider. At the same time, large-cap funds, excluding ETFs, saw their largest weekly net outflow since July 2012 investors week ending 2nd July.

"It was perhaps inevitable that many investors at the start of 2014 would question whether the strong gains for mid-cap stocks had run its course," said fund manager at Jupiter Asset Management, Steve Davies.

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At the start of the year, Davies thought a correction might be due, so he consolidated some of the gains and upped the proportion of cash in his portfolio.

But fast forward six months, the rotation out of smaller companies into large-cap stocks means the appeal of larger organizations has grown relative to the small and mid-cap sector, he said.

As a result, Davies has been adding to some of his existing small cap holdings, and his cash levels have come down from 10 percent to 5 percent.

Loan growth for U.S. smaller companies is double that of large caps and underperformance at the start of the year was largely down to the harsh weather, said head of global equity strategy at Coutts, James Butterfill.

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"Relative to history, both small caps and large caps tend to behave the same just before a rate hike, both tend to fall around 7 percent prior to a rate hike, which we see as a buying opportunity in both small and large caps," he added.

U.K. based fund manager, J O Hambro Capital Management which has £13.7 billion ($23 billion) under management recruited a small and mid-cap equities team earlier this month, ahead of the launch of a global small cap strategy for European investors.

Colas, however is not convinced.

"So will small caps start to outperform large caps now that their performance has reset to the market averages? I tend to doubt it," said Colas.

"First, with the European Central Bank's aggressive monetary policies, current and future, will create hope for a better 2015 on the continent. Larger companies tend to have more overseas operations than smaller ones, so they stand to benefit from those moves," he said.

The economic picture in the U.S. is also likely going to remain "tenuous" for much of the third quarter and perhaps into the fourth, Colas said, meaning larger companies tend to be more defensive than higher-beta small caps.

"Investors looking for equity exposure will likely dust off the late-cycle playbook and move upstream just in case the hoped for acceleration does not come to fruition," he added.

By CNBC's Jenny Cosgrave: Follow her on Twitter @jenny_cosgrave