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Small-Cap ETFs Underperforming: Be Choosy With 5 Top Picks

Sanghamitra Saha

Small-cap fund iShares Russell 2000 ETF (IWM) underperformed the S&P 500 this year consistently. A dovish Fed, heightened trade war tensions, global growth worries, geopolitical risks and a decently growing U.S. economy could lift pint-sized stocks as much as the large-cap ones (read: Top ETF Events of 1H Worth Watching in 2H).

Investors should note that small caps are domestically focused and are less scathed by trade tensions or global slowdown. These companies with lesser foreign exposure take a leap if the concerned economy is improving and the currency is strengthening.

However, the case was not simple this year. The small-cap fund IWM is up 16.1% this year versus 18.9% gains recorded by the S&P 500 and 22.7% returns offered by the Nasdaq.  Despite renewed tariff tensions in the second quarter, the benchmark Russell 2000 Index of small companies underperformed the S&P 500, the Dow Jones and the Nasdaq.

The Russell 2000 is up about 16% year to date, still more than 8% below the record highs it reached in August 2018. On the other hand, the large-cap S&P 500 is hovering around record highs (read: 5 ETF Strategies to Win in a Pricey Market).

Why?

Small caps are reeling under pressure. Margin pressure is weighing on the small-cap segment. Barclay’s now estimates that small caps will post EBITDA growth of 2% this year, down from its estimate of 5.5% growth earlier this year. 

For the second quarter, earnings decline for the small-cap index S&P 600 is expected to be 8.8% on 3.3% higher revenues. On the other hand, the earnings slump of the large-cap S&P 500 is expected to be 2.9% on 4.3% higher revenues, per the Earnings Trends published on Jun 26, 2019.

As many as 11 S&P 600 sectors out of the total 16 will likely produce negative earnings growth, of which six will witness a sharp double-digit slump. On the contrary, eight out of 16 S&P 500 sectors will likely see earnings decline, of which four are likely to represent a double-digit slump.  Overall, results of the pint-sized stocks have been pretty downbeat compared with the S&P 500.

Moreover, the tax reform or tax cuts were a boon to the segment last year. The move favored small caps more as “companies in the small-cap Russell 2000 pay a median effective tax rate of 31.9 percent, while the larger, multinational companies in the S&P 500 pay a median effective tax rate of 28 percent,” per Thomson Reuters data.

Any Hidden Jewels?

Against the above backdrop, investors need to be very choosy while including any small-cap ETFs in their portfolio. Below we highlight five such quality products. These have a Zacks Rank #2 (Buy).

Invesco Russell 2000 Dynamic Multifactor ETF (OMFS)

The underlying Russell 2000 OFI Dynamic Multifactor Index is constructed using a rules-based methodology by selecting equity securities from the Russell 2000 Index. The securities are assigned a multi-factor score from one of five investment styles: value, momentum, quality, low volatility and size. The fund charges 39 bps in fees (read: 10-Year Bull Market to Rage Ahead in 2019: 10 ETF Bets).

Invesco PureBeta MSCI USA Small Cap ETFPBSM

The underlying MSCI USA Small Cap Index measures the performance of the small-capitalization segment of the U.S. equity market. The fund charges 6 bps in fees.

Xtrackers Russell 2000 Comprehensive Factor ETF (DESC)

The underlying Russell 2000 Comprehensive Factor Index is designed to capture exposure to five factors Quality, Value, Momentum, Low Volatility and Size. The fund charges 30 bps in fees.

Goldman Sachs ActiveBeta U.S. Small Cap Equity ETF GSSC

The underlying Goldman Sachs ActiveBeta U.S. Small Cap Equity Index is designed to deliver exposure to equity securities of small-capitalization U.S. issuers. The fund follows a performance-seeking methodology that looks to pick stocks based on four attributes of performance: good value, strong momentum, high quality and low volatility. The fund charges 20 bps in fees.

Vanguard Small-Cap ETF VB

The underlying CRSP US Small Cap Index includes U.S. companies that fall within the bottom 2-15% of the investable market capitalization. The fund charges 5 bps in fees.

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