Something's Afoot With Small-Cap ETFs

The iShares Russell 2000 Index ETF (NYSE:IWM) and other well-known small-cap benchmarks have lagged the S&P 500 in the rally off the market's September lows, but some signs point to small caps erasing those recently established laggard status.

For example, investors are showing renewed faith in small caps. Although IWM is still lighter by $2.44 billion year-to-date, the largest small-cap ETF has hauled in $164 million in new assets since the start of the current quarter after bleeding $695.5 million in the third quarter.

Additionally, there are macro catalysts, including a stronger dollar, which could make an ETF such as IWM a compelling near-term idea.

If you believe that there will be some alleviation in tighter financial conditions, or that the US economy is once again bottoming out, or that the US dollar has resumed strengthening (i.e. small caps have less international revenue exposure) then IWM is a candidate for catch up, said Rareview Macro founder Neil Azous in a note out Sunday evening.

Small-Cap Volatility

Perhaps encouragingly, small-cap volatility is waning, as reported last week.

"Small-cap market volatility measures have told a different story this October to-date. As of October 16, the average closing price for the CBOE Russell 2000 Volatility Index (RVX) is 20.74, well below its long-term average closing price of 25 and significantly below the long-term average closing price in October of 29," according to FTSE Russell, the index provider behind IWM.

A Closer Look At IWM

Recently, IWM has been hindered by declines in biotechnology stocks. 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 14 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.

Financials are the largest sector weight in IWM at nearly 26 percent followed by technology at 17.7 percent.

Additionally, the characteristics between private equity and public small-caps are much more similar than they are to large-caps. As a result of struggling over the past few months private equity firms have gone out into the marketplace and hedged part of their risk by getting short of the Russell 2000. While it is not the only reason, it is certainly one of the key reasons why the ratio of small-to-large capitalization stocks (IWM/SPY) closed at a decisive new low for 2015 last Friday, added Azous.

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