After The Rally, Concerns Abound For Small-Cap ETFs

Since Election Day, small-cap stocks and exchange-traded funds have been enjoying a blistering pace, but that rally is eliciting concern among some market observers. For example, the iShares Russell 2000 Index (ETF) IWM is up 13.3 percent over the past month, but there are signs some of the enthusiasm for small caps is waning as highlighted by IWM's 2.3 percent decline last week.

Passive small-cap ETFs, such as IWM, and related index funds are popular with investors of all stripes for other reasons, including the inability of many active small-cap managers to beat their benchmarks. For the year ended June 2016, just 4 percent of active small-cap managers outperformed the S&P SmallCap 600 Index, but the average annual fee on a U.S. active small-cap fund is 1.2 percent per year, or $120 on a $10,000 investment.

Small-Cap ETFs' Rip

One reason small-cap ETFs have recently surged is the strong dollar. The U.S. Dollar Index is higher by 3.4 percent over the past month, boosting the thesis for smaller stocks, which often derive more of their revenue from within the confines of U.S. borders than international markets.

“Many have pointed to the strong U.S. dollar to explain the small cap outperformance. The argument is a strong dollar supports America’s purchasing power, which helps smaller, domestically-focused companies while hurting larger, more export-oriented firms. This explanation has intuitive appeal, but it ignores two issues,” said BlackRock in a recent note.

USD And Small-Cap ETFs' Relationship

Investors may do well to temper their expectations regarding an ongoing small-cap rally should the dollar continue climbing. As BlackRock noted, historical data indicate small caps and the greenback are not intimately correlated.

“Since 2000 the relative performance of small caps versus large caps has actually had a low correlation with changes in the dollar. While the correlation was negative at one point, it has historically been weak, explaining less than 1 percent of monthly relative returns. In short, although commentators have attributed small caps’ outperformance to a rallying dollar, history suggests otherwise,” said BlackRock.

Risk-tolerant traders looking to position for retrenchment in the major small-cap benchmarks may do well to consider the Direxion Daily Small Cap Bear 3X Shares TZA. TZA attempts to deliver triple the daily inverse returns of the Russell 2000.

Underscoring the point that leveraged ETFs are best used as short-term, intraday trades is the fact that TZA can and does deviate from the performance of the Russell 2000. For example, over the past month, TZA's variance, translated as its beta multiplied by the underlying index, is nearly 4.6 percent, according to issuer data.