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Three Reasons to Bet on Small Cap ETFs Now

Sweta Killa

While the broad stock market turned bullish after a nasty spell of trading, small caps are outperforming. This is especially true as the ultra-popular small-cap ETF IWM has gained 3.9% in one month compared with the addition of 2.4% for the large-cap cousin SPY and 2.3% for the mid-cap counterpart IJH (read: Market Hits New Record High: Growth ETFs Top).

We have highlighted several reasons for their continued outperformance:

Tax Reform Hopes

The impressive gains came mainly on hopes of tax reform, which is expected by the end of the year. If Congress approves the corporate tax rate cut from 35% to 15% as President Trump has proposed, small caps will the biggest beneficiaries relative to big companies. This is because companies on the small cap index Russell 2000 pay a median effective tax rate of 31.9% while the larger, multi-national companies on the S&P 500 pay a median effective tax rate of 28%, according to Thomson Reuters data. The median tax rate for the 30 mega-cap stocks on the Dow Jones Industrial Average is even low at 23.8%.

As a result, small caps have risen 5% since hitting low for the year on Aug 21, when Trump renewed his push for tax reforms. This is nearly double the 3% returns for the large caps. The summary of the bill is expected during the week of Sep 25. Additionally, lofty large-cap valuation, North Korea tension and chances of an end to the cheap monetary policy era across the globe have added to the strength in small-cap stocks (read: Bet on These ETFs on New Hopes for Tax Reform).

Upbeat Data

Growth in the U.S. economy is on a solid path buoyed by an impressive labor market, increase in wages, increasing consumer spending and high consumer confidence. Notably, U.S. GDP expanded 3% year over year in the second quarter, up from the previous reading of 2.6% and represented the fastest pace in more than two years. Consumers also appear more optimistic with the Consumer Confidence Index, as indicated by the Conference Board, surging to the second-highest level since late 2000 in August (read: U.S. Q2 GDP Revised Upward: ETFs in Focus).

Against such a backdrop, small-cap stocks are the biggest beneficiaries as these are closely tied to the U.S. economy and do not have much exposure to the international market. These pint-sized stocks generate most of their revenues from the domestic market and generally outperform on improving American economic health. Further, these are free from the clutches of any political malaise like political grid in Washington.

Fed Rate Hike

After hiking rates in December 2015 and December 2016, the Fed has raised interest rates two times this year and looks to hike rates again later this year. This indicates a stronger economy and is in turn propelling small-cap stocks higher. Investors’ should note that the fastest pace of increase in August inflation since spring increased the odds of a rate hike in December. The market is now expecting more than a 50% chance of a December rate hike, up from about a 30% chance one week ago, according to CME Group’s FedWatch Tool.

While there are several options to play on the bullish trends, we have presented five small cap growth ETFs that tend to gain more than their counterparts in such a trending market. All these funds have a Zacks ETF Rank #2 (Buy), suggesting their outperformance in the coming months too (see: all the Small Cap ETFs here).  

Guggenheim S&P SmallCap 600 Pure Growth ETF RZG

This fund tracks the S&P SmallCap 600 Pure Growth Index, charging investors 35 bps in annual fees. Holding 148 securities in its basket, it is well spread out across components with each holding less than 2.4% share. Health care and information technology take the top two spots with over 21% share each while consumer discretionary, industrials, and financials round off the top five with a double-digit allocation each. The fund has amassed $205.4 million in its asset base while trades in light volume of about 10,000 shares a day on average. It has gained 1.6% in a month.

First Trust Small Cap Growth AlphaDEX Fund FYC

This fund provides a slightly active choice as it uses the AlphaDEX methodology to select the stock. This approach results in a basket of 261 stocks, which are widely spread across securities with each holding less than 1% share. From a sector look, information technology takes the top spot at 25% while health care, financials, industrials and consumer discretionary also receives double-digit exposure each. The product has $124.3 million in AUM and charges 70 bps in annual fees. Volume is paltry with 21,000 shares exchanged a day on average. The ETF was up 3.5% in the last one month.

Vanguard Russell 2000 Growth Index ETF VTWG

This fund follows the Russell 2000 Growth Index. It provides diversified exposure to a broad basket of 1,194 stocks as none of these holds more than 0.7% of assets. About one-fourth of the portfolio is allotted to health care while technology, producer durables, consumer discretionary and financial services also take double-digit exposure each. The product has amassed $196.5 million in its asset base while volume is light at 8,000 shares a day on average. The ETF surged 2.9% in the same time frame (read: How to Build a Winning ETF Portfolio for Second-Half 2017).

iShares Russell 2000 Growth ETF IWO

This is one of the popular and liquid ETFs in the small cap space with AUM of $8.2 billion and average trading volume of 508,000 shares a day. The fund provides exposure to a broad basket of 1,158 stocks whose earnings are expected to grow at an above-average rate relative to the market by tracking the Russell 2000 Growth Index. It is well spread out across components as none of these holds more than 0.9% of assets. Sector wise, health care and information technology take the top two spots at 24.7% each, leaving a decent allocation for the others. The fund charges 24 bps in annual fees from investors and has gained 2.8% in a month.

iShares Morningstar Small-Cap Growth ETF JKK

This ETF offers exposure to small-cap companies whose earnings are expected to grow at an above-average rate relative to the market. It follows the Morningstar Small Growth Index and holds 256 securities in its basket with none accounting for more than 1.01% of assets. Information technology accounts for the largest share of 31.7% while health care, industrials, and consumer discretionary round off the next three spots. The ETF charges 30 bps in annual fees and trades in a light volume of about 3,000 shares a day. It has amassed $131.8 million in its asset base and returned about 3% in the same period.

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