Hello! This is markets reporter Isabel Wang bringing you this week’s ETF Wrap. In this week’s edition, we take a look at small-cap ETFs, which attracted significant inflows in the past week as small-cap stocks have rebounded after being left behind by the megacap technology shares which soared in 2023.
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U.S. small-capitalization shares are finally starting to join the stock-market rally this week as hopes for a soft landing help drive gains in some of 2023’s worst performers, while megacap technology stocks are taking a breather from its artificial intelligence-driven advance.
The small-cap Russell 2000 index
The iShares Russell 2000 ETF
Earlier this year, small caps were left in the dust by the stock-market bounce with the Russell 2000 struggling with fallout from regional bank strains and potential economic slowdown. The small-cap index has gained 6.5% since the collapse of Silicon Valley Bank on March 10, compared with a 11.1% gain for the S&P 500
Smaller-cap companies are often the canaries in the stock market’s coal mine and traditionally serve as bellwether in terms of the broader economic landscape, with their shares usually leading in market recoveries, or selling off faster before the broader market does during periods of economic downturns.
Paul Baiocchi, chief ETF strategist at SS&C ALPS Advisors, said the resurgence in small-cap stocks may mean that investors are starting to reposition toward small-cap names either in anticipation of a recession, or for the eventuality of the U.S. economy coming out of a recession.
Data from the U.S. Bureau of Labor Statistics Friday showed there were 339,000 jobs created in May, topping Wall Street estimates for 195,000 and underscoring the resilience of the U.S. economy in the face of rising borrowing costs.
Meanwhile, Fed-funds futures traders priced in a 72.4% probability that the Federal Reserve will leave interest rates unchanged at a range of 5.0% to 5.25% after its meeting next Wednesday, according to the CME FedWatch tool.
“With all the ongoing debate regarding the state of the economy, and concerns about an impending recession, steady interest in small-caps suggests the economy is more resilient than the headlines imply, or that a recession could be milder than initially projected,” said Quincy Krosby, chief global strategist at LPL Financial, in emailed comments on Wednesday.
“The market tends to ‘get the news first,’ and if it flows into the Russell 2000 advance, this could be a significant market signal,” she said.
Yet while fading recession concerns and cheap valuations may have small-cap stocks looking attractive, blindly chasing their rally is not without risk, warned Baiocchi.
Many of the small-cap companies, often technology startups and healthcare companies in the biotech space, don’t have strong profitability or even positive profitability, which now becomes a bigger problem than five or ten years ago when the Fed established a near-zero target range for the federal funds rate, said Baiocchi.
“You can fill the gap of operational shortcomings from a profitability perspective with borrowing because it is still cheap, but if rates are going to be elevated, then that could be a real challenge especially for the small-cap companies,” Baiocchi told MarketWatch in a phone interview on Thursday.
That is why investing in small-cap ETFs with a cap-weighted or an index-based approach has drawbacks as investors might catch in their nets some of the worst operators in an already risky segment of the market.
Baiocchi said investors need to focus on higher quality companies in the small-cap universe. For example, the ALPS O’Shares U.S. Small-Cap Quality Dividend ETF
Investor could “take the universe that everyone seems to own but reconfigure it toward companies that are more likely to persist in an environment where borrowing costs are higher and the economic backdrop is a little bit more challenging,” said Baiocchi.
As usual, here’s your look at the top- and bottom-performing ETFs over the past week through Wednesday, according to FactSet data.
SPDR S&P Regional Banking ETF
SPDR S&P Bank ETF
Invesco S&P Small-Cap Value with Momentum ETF
EA Bridgeway Omni Small-Cap Value ETF
Avantis U.S. Small Cap Value ETF
|Source: FactSet data through Wednesday, June 7. Start date June 1. Excludes ETNs and leveraged products. Includes NYSE, Nasdaq and Cboe traded ETFs of $500 million or greater.
…and the bad
Quadratic Interest Rate Volatility & Inflation Hedge ETF
VanEck Junior Gold Miners ETF
VanEck Gold Miners ETF
iShares MSCI Germany ETF
PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF
Franklin Templeton Thursday launched the Franklin Income Focus ETF
-0.11%, the firm’s first multi-asset ETF on the New York Stock Exchange. The fund invests in a multi-asset, diversified portfolio of equity and debt securities which could adjust and adapt to changing market conditions, the company said on Thursday. Equity securities within the portfolio may include common stocks, dividend-paying stocks, as well as convertible preferred securities. Debt securities may include all varieties of fixed, floating and variable rate instruments.
Weekly ETF Reads
- Climate-related ETFs rise as U.S. stocks mostly fall (MarketWatch)
- Buffett-inspired ETP puts innovation in the hot seat (Financial Times)
- ‘Fear of missing out’ drives retail investors to ride AI wave (Financial Times)
- Biggest Junk-Bond ETF Attracts Most Cash Since 2020 as Rally Builds (Bloomberg)