Small-cap ETFs may look attractive as recession concerns fade, but blindly chasing the rally is not without risk

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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
RUT,
-0.80%,
which tracks the smallest 2,000 companies in the broader Russell 3000
RUA,
+0.02%
by market capitalization, has risen 2.8% this week. It outperformed the Nasdaq Composite
COMP,
+0.16%
by 5.04 percentage points month-to-date as of Wednesday, its largest outperformance in the first five trading days of a month since October 2020, according to Dow Jones Market Data.

The iShares Russell 2000 ETF
IWM,
-0.81%,
a passively managed exchange traded fund that tracks the small-cap index, saw inflows of $2.03 billion in the week to Wednesday. It also captured the largest inflows among over 800 ETFs that MarketWatch tracked in the past week, according to FactSet data. 

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
SPX,
+0.11%
and a 18.8% advance for the Nasdaq Composite over the same period, according to FactSet data. 

See: Small-cap stocks surge as broader U.S. market stalls. Here’s why.

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. 

See: Why stock-market investors should beware of chasing small-cap rally

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
OUSM,
-0.39%,
which tracks small and mid-cap companies and screens for companies’ return on assets, profitability, balance sheet quality, dividend growth and volatility.

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.

The good…

…and the bad

New ETFs

• Franklin Templeton Thursday launched the Franklin Income Focus ETF
  INCM,
  -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