Yes, Small-Cap ETFs Work When Rates Rise

It has been mentioned many times during the recent small-cap rally that smaller stocks and the exchange-traded funds that hold them can be viable destinations for equity investors are interest rates rise.

That is not just talk. Data confirm as much. Last year, the iShares Russell 2000 Index (ETF) IWM and the iShares S&P SmallCap 600 Index (ETF) IJR, two of the largest, most liquid small-cap ETF, took in more than $10.1 billion in new assets combined IJR and IWM rewarded investors' faith by returning an average of 23.6 percent, nearly double the 12 percent gained by the S&P 500.

Correlation, Causation?

Data suggest it was not coincidental that small-cap stocks and ETFs were surging in unison with 10-year Treasury yields. The Russell 2000 has a sensitivity, or beta, to 10-year Treasury yields of 0.060 while the comparable metric for the S&P SmallCap 600 is 0.056, according to S&P Dow Jones data.

“We can see that, on average, both small-cap indices have positive exposure to rate increases. In particular, the Russell 2000 exhibited slightly higher positive sensitivity to changes in rates. For every 1 percent positive change in 10-Year yield, the returns of S&P SmallCap 600 increase by 5.6 percent on average, whereas the returns of Russell 2000 increase by 6 percent. However, the difference in coefficients (sensitivities) of the two indices is not statistically significant at the 95 percent confidence level,” said S&P Dow Jones in a recent note.

Small caps generate the bulk of their revenue within the United States, making them less vulnerable to the stronger dollar than large-cap multinationals and possible beneficiaries of any additional hawkish efforts by the Federal Reserve.

Explaining the correlation of an ETF like IWM to interest rates is not difficult. After all, the Russell 2000 and other small-cap benchmarks are highly cyclical at the sector level. For example, financial services, technology and industrial stocks, usually considered cyclical, combine for over 51 percent of IWM's weight.

Conversely, defensive utilities, consumer staples and telecom stocks combine for just under 7 percent of the ETF's weight.

Looking Back At What History Has Taught

Interestingly, historical data also confirm that the two aforementioned small-cap benchmarks usually fall when rates do the same but rise with borrowing costs and in neutral rate environments.

“The data shows that during those periods in which the 10-Year U.S. Treasury yields rose by more 50 bps, both small-cap indices delivered returns north of 7 percent on average. Similarly, during those periods in which 10-Year yields remained neutral or rose less than 50 bps, both indices still delivered positive returns of 4 percent or more.  Therefore, we can observe that neutral or rising rate environments can favor smaller-cap names. Conversely, during those periods in which yields decline by more than 50 bps, both small-cap indices posted negative returns, with the Russell 2000 losing more than the S&P SmallCap 600,” added S&P Dow Jones Indices.