The U.S. small-cap space has exhibited an impressive rally this year with the Russell 2000, posting its 18th record close for the year on Jun 6. Small-cap fund iShares Russell 2000 Index ETF (NYSEARCA:IWM) is up 5.2% in the past one month and 17.9% in the last one year. So far this year, IWM has advanced 7.9% while the S&P 500 is up 2.8% (as of Jun 7, 2018).
Though large-cap index S&P 500 started 2018 on a better footing than the Russell 2000, the game started changing from mid-March. President Trump’s protections agenda and the resultant trade war fears started weighing on large-cap stocks that have a considerable international exposure. And the domestically focused pint-sized stocks soared.
Since mid-March, there was no looking back for the Russell 2000 index, having outperformed its mid (Russell Midcap index) and large-cap (Russell 1000 index) counterparts for the third straight month through May.
Apart from its insulation from trade tensions, a fast-growing U.S. economy (compared with several other developed countries), a stronger greenback, a hawkish Fed, upbeat earnings and geopolitical tensions have favored the segment.
The tax reform is yet another tailwind to the segment as it is supposed to favor small-caps more. This is because companies in the Russell 2000 pay a higher median effective tax rate than the S&P 500, per Thomson Reuters. Now the question that arises is how long the rally will continue.
Will the Rally Continue?
The question is coming because many of the tailwinds have been priced in at the current level. The co-chief investment strategist of PNC Financial have doubts on the small caps’ record run. After such a strong rally, profit booking activity is also in the cards. Moreover, there is a glitch in the new tax law that can act as a deterrent to small-cap stocks.
There is a provision in the tax law that calls for limiting deductions to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years, and 30% of 12-month EBIT after 2021. Previously, the law entailed the full deduction of interest paid.
Per an article published on thestreet.com, many small-cap stocks are debt-reliant for their survival and lack cash, particularly the biotechs. Plus, interests should perk up next year given the Fed policy tightening and Trump bump. The double whammy of reduced interest deductibility and higher bond yields may actually weigh on small-cap stocks.
Given this, we would like to highlight some smart beta small-cap ETFs for investors. With these, investors can get a quality exposure of this presently-soaring segment. These funds have beaten IWM (up 6.1%) in the past three months (as of Jun 7).
RevenueShares Small Cap Fund (NYSEARCA:RWJ) – Up 7.9%
The underlying OFI Revenue Weighted Small Cap Index is built by re-weighting the constituent securities of the S&P SmallCap 600 Index according to the revenue earned by the companies on the S&P SmallCap 600 Index. It charges 39 bps in fees.
WisdomTree SmallCap Earnings Fund (NYSEARCA:EES) – Up 7.5%
The underlying index is a fundamentally weighted index that measures the performance of earnings-generating companies within the small-capitalization segment of the U.S. stock market. The fund charges 38 bps in fees.
JPMorgan Diversified Return U.S. Small Cap Equity ETF (NYSEARCA:JPSE) – Up 7.3%
The fund intends to offer U.S. small-cap equity exposure with potential for better risk-adjusted returns than a market cap-weighted index. No stock accounts for more than 0.91% of the fund. The fund charges 29 bps in fees.
USAA MSCI USA Small Cap Value Momentum Blend Index ETF (NYSEARCA:USVM) – Up 7.2%
The fund gives exposure to value and momentum factors to the U.S. small-cap segment. No stock accounts for more than 0.5% of the fund. The product charges 25 bps in fees.
iShares Edge MSCI Multifactor USA Small-Cap ETF (NYSEARCA:SMLF) – Up 6.8%
The fund picks U.S. small-cap stocks based on the criteria of value, quality, momentum and low size. No stock accounts for more than 1.28% of the fund. The fund charges 30 bps in fees.
SPDR SSGA US Small Cap Low Volatility Index ETF (NYSEARCA:SMLV) – Up 6.6%
The fund is designed to track the performance of U.S. small capitalization companies that exhibit low volatility. This fund also does not have company-specific concentration risk as the top holding has only 1.05% weight.
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