Why investors are betting on actively-managed small-cap ETFs

According to Strategas, only about 7% of small-cap ETF assets are held in actively-managed funds, yet those funds account for more than 40% of this year's fund flows into the small-cap ETF space. Why? As Strategas Securities ETF and Technical Strategist Todd Sohn explains in the video above, it likely has to do with what small-cap ETFs are investing in. Given higher interest rates, Sohn says, "the flaws have been exposed," pointing out that a lot of small-cap ETFs have high exposure to interest-rate sensitive sectors such as regional banks.

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Video Transcript

- Small caps moving higher today after rallying last week following positive economic data. Accounting for only 7% of managed assets, small-cap ETFs rake in 41% of year to date inflows. As part of our ETF report brought to you by Invesco QQQ, let's bring in Todd Sohn, Strategas Securities ETF and Technical Strategist to discuss more.

Thank you for joining us this morning. So talk about why we're seeing this rush of inflows when it comes to these small-cap ETFs, and how much upside you still see.

TODD SOHN: Yeah, I think it's great to put some context on here, right? It's been 500 days since small-caps last hit a new all time high. That's only the seventh time in history that that's occurred. So the bar for improvement from small-caps from here is very low.

Now, what I think has happened during this interest rate hiking cycle is that small-cap indices, the flaws have been exposed, right? There's too many regional banks. There's too much boom and bust biotech, zombie companies. And so you're seeing a lot of money flow towards actively managed strategies, particularly from companies like Avantis and Dimensional Fund Advisors, where they have a hand on the wheel here and can drive your small-cap investment towards the more higher quality small-cap companies. And so I think that's what you're starting to see here.

And if you're looking to diversify away from the large-cap growth exposures you have, consider small-caps. Consider actively managed small-caps. We think that makes sense heading into next year.

- And for people who were eyeing the volatility, looking at the Russell 2000 VIX, trading below its 20 year average as you note there. Why is that important to take a look at that, considering what else we're seeing with small-caps?

TODD SOHN: Yeah, I think the VIX gets a lot of undue attention, right? It's known as the fear barometer. But what is most important to us is that a low VIX, whether it's for the S&P 500 or for the Russell 2000, isn't something you should fear. Low VIX is actually consistent with markets that tend to rise, right, uptrend.

So historically, you have the small-cap VIX trading below its average right now, going back the last 20 or so years. And during those similar type of periods, you actually had pretty good performance from small-cap indices, whether it's the Russell 2000 or S&P 600.

And so I don't want investors to get deterred from seeing low volatility from a low VIX. You might see a headline out there that says, oh, this can only mean one thing, that there's negativity brewing, the complacency brewing. That is just frankly not true.

And so keep in mind the history here that low volatility is great for equities. That's what they like. They do not like any agitated by-- you know, unknown events, uncertainty, right? That's when you breed high volatility. So keep that bigger picture in mind, that the bar is low for small caps, and low volatility is your friend going forward.

- Good to keep in mind. Now, I want to also dig into some of the sectors here that are the most allocated among small-caps. Financials leading the charge. Industrials discretionary as well. How does that work for-- you we're in a higher for longer rate environment. But you know at some point, at least the market's pricing in a turnaround, pricing in rate cuts into 2024, whether that's right or wrong. How do you manage that? How do you consider-- how you should be playing the ETF market, keeping in mind that for the potential for rate cuts next year?

TODD SOHN: Yeah, it's a great question. So most small-cap ETFs have a very high allocation to financials because that's where all the regional banks live. And that's been a bit of a headwind next year. So I do suppose that a pause and perhaps a cut should help out those regional banks, right? It takes the interest rate pressure off of them. So that should be helpful.

And on the other hand, I think you're starting to see industrial exposure increase within those small-cap companies too, right? You think about manufacturing here in the US. That's at an all time high or has really exploded. And so those companies are benefiting too.

I think active managers are finding more high quality stocks within the industrial sector. And so as long as the economy remains on decent footing, the industrial-- small-cap industrial stocks should benefit. And those small-cap ETFs that have the exposure there, such as CALF or AVDV. They should benefit in this type of environment, whether we're on hold from the FED or whether there are cuts into next year at some point.

So I do like the outlook there, particularly those with the industrial exposure with the discretionary exposure. And ideally, the regional banks should benefit here. Again, the bar is really low. They've taken a beating this year. So you tend to wonder how much downside is actually left for those types of names.

- Indeed, especially after what we saw with the regional banking crisis still clawing back some of those gains. I want to ask you because a lot of people still chasing some of these yields, looking at money market funds. If they're trying to decide whether or not to go the ETF route versus traditional money market funds, how should they be weighing that decision?

TODD SOHN: It's a fantastic question. Money market funds have taken in a trillion dollars year to date and flows. It's one of the most aggressive areas out there. Now, it depends on what your need is. Money market funds, you only price one of them once a day at the close. Whereas if you're looking for a short duration treasury, you can get in and out of that throughout the day because ETFs are trading on the exchange.

So I think it depends on the end investor, right? You're not getting much of a difference in the result, whether you're buying a money market mutual fund or a short duration treasury ETF. But I think bigger picture perhaps, what's most important is that cash is the most popular investment out there right now.

I know we've had a lot of volatility in the last few years in equities. And you have interest rates that we haven't seen in 10, 15 years now. So it's almost like candy for a lot of investors out there.

So regardless of the vehicle, though, keep in mind cash is comforting, but there is a lot of opportunity cost associated with that, right? We see the S&P 500 up almost 20% year to date. So keep the longer term picture in mind when you start looking at money market funds and treasury ETFs too.

- Certainly. Good to keep in mind. Not a lot of people looking every day at every single movement here with every data point we get. But as you mentioned, taking that longer view certainly key. Appreciate you joining us this morning. Todd Sohn, Strategas Securities ETF and Technical Strategist. Thank you so much.