Small-capitalization stocks recently experienced a strong rebound, but it will take more for the asset category to maintain its momentum. Given the potential risks out there, investors may consider a smart beta small-cap exchange traded fund to limit potential drawdowns.
“Prospects of a corporate tax cut fanned the flames in the U.S. given small caps’ higher tax burden. But we believe a sustained run will require more than lower taxes,” BlackRock strategists, led by Richard Turnill, said in a research note.
While small-caps have strengthened on the prospect of the Trump administration’s pro-growth agenda and hopes of corporate tax cuts, the segment still lags behind U.S. large-caps and analysts have downgraded small companies’ earnings expectations for 2017.
Additionally, strong global economic growth and a weak U.S. dollar help support the outlook of large multinationals, which benefit from overseas trade, over small U.S. companies.
There is also lingering uncertainty for the small-cap energy segment as they are still adapting to the shale revolution.
Valuations are also not on small-caps’ side as the S&P 600 Small Cap Index is currently hovering around a 21x forward earnings and the broader Russell 2000 of small-cap companies shows a higher 27x.
“Bottom line: U.S. small caps have impressed recently, but have become relatively expensive and vulnerable to any tax reform disappointment. Rather than size, we believe investors are better served focusing on equity style factors with potentially greater staying power in a sustained above-trend expansion, particularly momentum and value,” according to BlackRock.
For example, the iShares Edge MSCI Multifactor USA Small-Cap ETF (NYSEArca: SMLF) focuses on small-cap companies that are screened for value, quality, momentum and low size. Additionally, the iShares Edge MSCI Min Vol USA Small-Cap ETF (BATS: SMMV) holds small-cap equities that have lower volatility characteristics relative to the broader equities market. Due to their indexing methodologies, the two ETFs exhibit greater small-cap value tilts.
The PowerShares DWA SmallCap Momentum Portfolio (NasdaqGM: DWAS) follows the popular Dorsey, Wright & Associates proprietary selection methodology that is designed to identify small-cap firms with positive relative strength characteristics in an attempt to follow companies with strong forward momentum.
Additionally, the Oppenheimer Small Cap Revenue ETF (NYSEArca: RWJ) follows a revenue weighting methodology, which could provide diversified exposure to the market, is not influenced by stock price, reflects a truer indication of a company’s value and offers stable sector exposure. Moreover, revenue weighting may provide a more value-oriented portfolio and historically outperformed in a value-driven market while showing lower drawdowns during growth-driven markets.
For more information on small-capitalization stocks, visit our small-cap category.