Getting It Wrong With Small-Cap ETFs

Small-cap stocks and the relevant exchange traded funds have been punished during the current quarter with the iShares Russell 2000 ETF (NYSE:IWM) entering Tuesday with a third-quarter loss of 12.9 percent.

That is 400 basis points worse than the S&P 500 over the same period and bad enough to have the largest small-cap ETF trading at its lowest levels in almost a year. However, some traders have missed a golden opportunity to profit from small-cap weakness with leveraged ETFs.

The fact that this opportunity has been missed is all the more egregious when considering the recent deterioration in the healthcare sector. Due to a spate of biotechnology initial public offerings over the past several years, many of which still sport market values that qualify as small cap, IWM's third-largest sector weight is just over 16 percent to healthcare. That is to say many of the healthcare stocks residing in the ETF are biotech names, making this broad market ETF vulnerable to the whims of the biotech space.

To be fair, investors have mildly responded to small-cap weakness by pulling almost $156.4 million from IWM in the current quarter as of September 28. Still, that is a scant percentage of the ETF's $25.6 billion in assets under management.

The lost opportunity with small-cap ETFs comes in the form of the Direxion Daily Small Cap Bear 3X Shares (NYSE:TZA). TZA, which attempts to deliver three times the daily inverse performance of the Russell 2000 Index, IWM's underlying benchmark, came into Tuesday with a third-quarter gains of 42.3 percent. That means TZA has actually been doing better than triple the inverse returns of IWM.

However, traders have mucked up this opportunity by pulling $333 million from TZA this quarter. Making matters worse is that TZA and its bullish counterpart, the Direxion Daily Small Cap Bull 3X Shares (NYSE:TNA), are replaying a scenario that is seen over and over again with leveraged ETFs.

The worst-performing member of the pair, in this case TNA with its third-quarter loss of 36.1 percent, is the one on the receiving end of investors' affinity and assets. TNA, which seeks to deliver three times the daily performance of the Russell 2000, has raked in almost $583.4 million this quarter. Think about that: Traders have added more money to a leveraged bullish small-cap ETF than they have pulled from IWM and TZA...combined.

Volume data confirm traders have preferred TNA to TZA in recent weeks. For the five days ended Monday, TNA's volume was 11.5 percent above the trailing 20-day average while TZA's turnover during that period was 15.7 percent below its 20-day average, according to Direxion data.