Vulnerable Sector is Weighing on Small-Cap ETFs | ETF Trends

The iShares Russell 2000 ETF (NYSEArca: IWM), which tracks the widely observed Russell 2000 Index of small-cap names, has been trailing large-cap benchmarks and ETFs, including the iShares Russell 1000 ETF (NYSEArca: IWB) and that situation has been worsening in recent months.

The diverging fortune between the small-cap and large-cap segment is a cause for concern for some investors. Small-cap stocks, which focus more of on the domestic economy, typically strengthen ahead of a wider market rally and fall more quickly ahead of a broader pullback.

In theory, small-cap stocks should be performing better than they are because of their domestic focus, a trait that should be advantageous at a time of heightened trade tensions. About 82% of the revenue from Russell 2000 companies is generated within the U.S. In comparison, around 50% of generate from S&P 500 companies is generated domestically.

IWM’s larger weight to financials, a sector that has been drubbed by declining interest rates, is plaguing the small-cap fund.

“While many factors impact size performance, sector exposures tell a big part of the story. A detailed look at industry weights helps explain recent small-cap underperformance,” said FTSE Russell Managing Director Alec Young in a recent note.

Which Sector Wins

IWM allocates over 22% of its weight to financial services stocks, which are vulnerable to declining net interest margins at the hands of lower interest rates. Conversely, the large-cap IWB has a weight of less than 13% to that sector.

“It’s no secret technology has been strongly outperforming the financial sector as a flattening yield curve and unprecedented declines in interest rates squeeze bank profits,” said Young. “The small-cap benchmark sports for a hefty 27% financial industry weight vs. only 21% for its large-cap counterpart. What’s more, large caps also have greater exposure to technology performance leadership with a 22% weight versus only 13% for the Russell 2000 Index.”

For investors looking for continued upside in large-cap equities over small caps, the Direxion Russell Large Over Small-Cap ETF (NYSEArca: RWLS) offers them the ability to benefit not only from large-cap equities potentially performing well but from their outperformance compared to their small-cap brethren.

Related: Is It Time to Reconsider Small-Cap ETFs?

“The financial sector has had a very strong correlation with the direction of US treasury yields for several years and has begun to perk up as rates have stabilized,” said Young. “As for technology, the sector’s valuation premium is now well above its historical average reflecting structural growth tailwinds that are now widely appreciated. All this means that it may be time to re-evaluate small-cap allocations.”

Conversely, if investors believe that small-cap equities will outperform large-cap equities, the Direxion Russell Small Over Large-Cap ETF (NYSEArca: RWSL) provides a means to not only see small-cap stocks perform well, but a way to capitalize on their outperformance versus their large-cap brethren.

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