Peaking To 2016, Small-Cap ETFs Look For Better Days

When measured against large-cap benchmarks such as the S&P 500, small-cap stocks and exchange-traded funds have disappointed this year. For example, the iShares Russell 2000 Index (ETF) (NYSE:IWM) is up just 0.2 percent, while the iShares S&P SmallCap 600 Index (ETF) (NYSE:IJR) is higher by 2.6 percent. Both small-cap ETFs lag the 2.9 percent returned by the SPDR S&P 500 ETF Trust (NYSE:SPY).

Small Caps, Large Caps And The Rising Dollar

Throughout 2015, investors have heard about small-cap strength by way of the rising dollar, which implies small-cap stocks and the exchange-traded funds that hold them should be beneficiaries of rising interest rates. Obviously, that scenario has yet to materialize in earnest. Making matters worse is the fact that small-caps have lagged large-caps even as the latter's earnings have been hampered by the rising dollar.

Related Link: An Inexpensive Small-Cap ETF For December Gains

While a stronger dollar provides less of a headwind for small-cap companies, the dollar has been strengthening in the context of pending Federal Reserve (Fed) tightening and less benign credit markets. The latter point is particularly important for small caps, which perform best when credit conditions are easing, BlackRock Global Chief Investment Strategist Russ Koesterich in a recent note.


Currently, investors are hearing quite a bit about favorable small-cap seasonality. Over the past 90 days, IJR and IWM are up an average of 5.4 percent. That sounds impressive, until considering that SPY is higher by 7.3 percent over the same period.

However, investors are responding to the notion this is the time of year to buy small-cap ETFs. Since the start of the fourth quarter, IWM has added $1.6 billion in new assets, while IJR has seen inflows of nearly $374 million.

IJR, which actually holds 602 stocks, not 600, charges a scant 0.12 percent per year. That works out to be just $12 per $10,000 invested, making IJR one of the most cost-effective small-cap ETFs on the market today.

While small-cap ETFs, such as IJR and IWM may honor their aforementioned seasonality, there are still areas of concern, including frothy valuations and tightening credit spreads scenarios that usually are not encouraging for smaller stocks.

The key lesson is to watch not only earnings, but also what investors are willing to pay for those earnings. While I dont expect a significant deterioration in credit markets next year, conditions are turning less favorable: corporate leverage is higher, default rates are rising and with oil hovering near $40, energy issuers are at risk. If spreads do continue to widen in 2016, theres a case for again tilting toward the safety of larger firms, added Koesterich.

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