How Small-Cap ETFs Can Deal With the Fed

As has been widely documented, major small-cap exchange traded funds, including the iShares Core S&P Small-Cap ETF (NYSEArca: IJR) and the iShares Russell 2000 ETF (NYSEArca: IWM), have struggled to start 2017. The Federal Reserve’s first interest increase of 2017, unveiled last week, has some investors concerned about the near-term outlook for smaller stocks.

Small-caps, though, can still navigate through a slowly rising rate environment. Smaller companies, which focus on U.S. markets, are less exposed to a stronger U.S. dollar as rates rise, which would more negatively affect larger corporations with a global footprint. Additionally, periods of rising rates also coincide with expanding economies, which often benefit smaller companies.

Small-caps are also focused on the domestic economy and have less direct exposure to global geopolitical uncertainty and currency risks, as opposed to large-cap companies that have an international footprint, which may be affected by overseas risks and a strengthening U.S. dollar.

Index returns in each of the last four cycles have been negative after one month, but in the three most recent cycles, index returns were up by double-digits after one year. The 2015 cycle had the largest trough-to-peak swing, down -12.3% after one month, but up 22% after twelve months – a remarkable 34.3 percentage point turnaround,” according to FTSE Russell data regarding the performance of the Russell 2000 during previous Fed tightening cycles.

Expansionary fiscal policies have fueled inflation expectations, which have in turn raised bets on a Federal Reserve interest rate hike and strengthened the U.S. dollar. Consequently, with a stronger U.S. dollar, large-cap stocks may underperform as many large exporters find it harder to sell goods to foreign markets.

Still, investors have not been apprehensive about putting new money to work with small-caps this year.

In addition, analysis from XTF on asset flows into US-listed exchange traded products (ETPs) which track the US small cap equity market show a similar trend. $8.8 billion in net assets flowed into US small cap ETPs in 2016 leading up to the November 8 presidential election. This number increased to $15.3 billion between election day and the end of the year. And in 2017, US small-cap ETP flows have remained strong, with $8.4 billion in net flows through March 14,” according to FTSE Russell.

IWM, which follows the Russell 2000 and is the largest small-cap ETF, is heavily allocated to cyclical sectors. Cyclicals usually perform well as rates rise. Financials, technology and industrial names combine for over half the ETF’s weight.

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