Outperforming Small-Cap ETF Strategies

Small-capitalization stocks have led the rally off the February lows, nimbly outpacing their larger counterparts. Within the small-cap asset category, exchange traded funds that track alternative or smart-beta indexing methodologies have been standouts.

The widely observed iShares Russell 2000 ETF (NYSEArca: IWM), which tracks the Russell 2000 Index, has rallied 16.2% off its February 11 low as relatively strong U.S. economic data and a dovish Federal Reserve helped small U.S. stocks stage a rebound from the sell-off earlier this year. Nevertheless, the pullback at the start of the year remains a drag on the small-caps, with IWM still down 1.9% year-to-date.

The small-cap segment was able to jump on the risk-on sentiment in March after the Fed stated it would only hike interest rates two times later this year, or downwardly revised from the four hikes it expected back in December. The extended low-rate environment has been a boon for smaller companies that have capitalized on cheap debt in their balance sheets.

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.

While small-caps have recently been outpacing large-cap stocks, potential investors should be aware that the small-cap segment comes with greater risks and can experience greater volatility, which we witnessed as smaller companies underperformed in the sell-off earlier this year.

Alternatively, investors can target small-cap stocks through a relatively new group of smart-beta ETFs. Due to their indexing methodologies, these smart-beta small-cap ETFs may lean toward more quality or conservative plays, which help cushion drawdowns but still allow investors to capture market returns. The improved risk-adjusted returns found in these types of strategies help investors win over the long-run by not losing as much in short-term corrections.

For instance, some of the top performing small-cap ETFs so far this year include options that track alternative indexing methodologies. Year-to-date, the ProShares Russell 2000 Dividend Growers ETF (NYSEArca: SMDV) increased 8.4%, WisdomTree U.S. SmallCap Dividend Growth Fund (NasdaqGM: DGRS) rose 4.7%, Compass EMP US Small Cap High Dividend 100 Volatility Weighted Index ETF (NasdaqGM: CSB) advanced 4.6%, SPDR S&P 600 Small Cap Value ETF (NYSEArca: SLYV) added 3.2% and Oppenheimer Small Cap Revenue ETF (NYSEArca: RWJ) was up 3.0%. In comparison, the S&P 500 Index returned 1.8% so far this year.