Of Rate Hikes And Small-Cap ETFs

For a good portion of this year, investors have been regaled with tales of alleged 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.

That has not been the case as the iShares Russell 2000 ETF IWM, the largest small-cap ETF, has fallen half a percent year-to-date while the S&P 500 is higher by nearly one percent. The iShares Core S&P Small-Cap ETF IJR has been better with a 1.5 percent year-to-date gain, but that is far from awe-inspiring.

With the Federal Reserve seemingly on course to raise interest rates in December, investors should be pondering what the near-term holds for ETFs such as IJR and IWM. However, the coming up with a firm answer is not easy. On the upside, one rate hike from the Fed, regardless of timing, likely will not be the only factor in determining small-cap performance.

“Whether or not the Fed decides to raise rates in December, January, or April is unlikely to be the primary determinant of how the broader U.S. market performs. However, there are certain segments of the market that are more sensitive to changes in monetary policy and may benefit from any delay by the Fed,” said BlackRock Global Chief Investment Strategist Russ Koesterich in a recent note. 

What is interesting is that investors have embraced small-cap ETFs in the current quarter and have been rewarded for that faith. Since the start of the fourth quarter, IWM has climbed 6.5 percent while raking in over $1.1 billion in new assets. IJR has hauled in $20.1 million in new assets on its way to a fourth-quarter gain of 6.8 percent. 

Even with significant exposure to financial services stocks, and smaller financials should benefit from higher interest rates, rising real rates are seen as a drag on small-cap stocks and ETFs.

“The culprit: rising real rates, which tend to negatively impact small cap valuations more than those of large cap firms, as Bloomberg data show. Historically, small cap relative performance has been strongest when short-term rates–those controlled by the Fed–are falling,” adds Koesterich.

Refining the small-cap universe into value and growth, in the fourth quarter, investors have preferred value. The iShares Russell 2000 Value ETF IWN has added over $161 million in new assets this quarter while its growth counterpart has lost assets.

IWN allocates nearly 44 percent of its weight to financial services stocks compared to a 25.6 percent weight to the same sector found in IWM.