Trying To Find Hope For Small-Cap ETFs

U.S. large-cap stocks and the related exchange traded funds have been solid performers this year, but small-cap equities and ETFs are lagging. For example, the iShares Russell 2000 ETF (NYSE:IWM) is clinging to a year-to-date gain while the iShares Core S&P Small-Cap ETF (NYSE:IJR) has traded slightly lower.

Struggling small-cap ETFs are catching investors by surprise because smaller stocks surged immediately following the 2016 U.S. presidential election. Additionally, small-caps were expected to continue rolling this year against the backdrop of higher interest rates from the Federal Reserve and the Trump Administration's efforts to bolster the U.S. economy.

Data suggest it wasn't coincidental that small-cap stocks and ETFs were surging in unison with 10-year Treasury yields. The Russell 2000 has a sensitivity, or beta, to 10-year Treasury yields of 0.060, while the comparable metric for the S&P SmallCap 600 is 0.056, according to S&P Dow Jones data.

Still, small-caps are scrambling for catalysts at the moment. Add to that, small-caps are pricey even relative to their long-term averages.

The Russell 2000 was already expensive last December; at nearly 48x trailing earnings it is even more so today. Instead, many investors are starting to look for better bargains overseas, BlackRock said in a recent note.

IJR, which tracks the S&P SmallCap 600 Index, isn't particularly cheap, either. That ETF sports a P/E ratio of almost 23. IJR allocates over half its weight to industrial, financial services and consumer discretionary stocks. IWM, the Russell 2000 tracking ETF, allocates over half its combined weight to financials, technology and industrial names.

A near-term issue for smaller stocks is waiting on Washington for catalysts, a proposition that can often end in disappointment for investors.

What could reverse this recent trend? The most obvious catalyst would be events in Washington, BlackRock said. Progress on tax reform and infrastructure spending would help convince increasingly skeptical investors that the long hoped-for fiscal stimulus will actually materialize. In the absence of that, investors may be looking at a more modest version of the reflation trade than many discounted last fall. Under this scenario, small caps may not regain their luster anytime soon.

Year-to-date, investors have pulled almost $2.5 billion from IWM. IJR has added $2.9 billion in new assets.