Some Small-Cap ETFs Have Been Total Duds This Year

The operative word in that headline is “some” because it must be noted some small-cap exchange traded funds have delivered impressive returns this year, but, broadly speaking, smaller stocks have been disappointed.

Enter the phrase “small-cap ETFs strong dollar” into your search engine of choice and you'll likely find plenty of articles from credible sources espousing the virtues of small-caps in a strong dollar environment. The theory is that smaller companies should thrive when the dollar rises because these companies generate the bulk of their revenue within the confines of U.S. borders.

Well, that has been a theory for sure this year, but far from a law. The iShares Russell 2000 ETF IWM and the iShares Core S&P Small-Cap ETF IJR are up an average of 1.6 percent, barely more than half the 2.5 percent returned by the S&P 500. This is a glaring gap because on small caps are notoriously more volatile than their larger peers, meaning investors are not being adequately compensated for the risks associated with small-cap ETFs this year.

Add to that, IWM and IJR are lagging while the PowerShares DB US Dollar Index Bullish Fund UUP, the Dollar Index tracking ETF, is up six percent year-to-date, dealing a blow to the aforementioned theory about small caps and the greenback. BlackRock Chief Investment Strategist Russ Koesterich notes part of the problem is that small caps are proving vulnerable to rising interes rates. 

“During earnings season, investors worried about the impact of a flattening yield curve on small cap banks, which make up roughly 25 percent of the Russell 2000, according to Bloomberg data. In addition, consistent with history small cap earnings multiples are proving more vulnerable to a tightening in monetary conditions. According to the Bloomberg data, in July, the trailing price-to-earnings ratio for the Russell 2000 contracted by roughly 2 percent, while S&P 500 gains were supported by multiple expansion of roughly 2 percent,” said Koesterich in a recent note.

To be fair, there are pockets of strength among small caps, mainly the funds that emphasize growth. For example, the iShares Russell 2000 Growth ETF IWO is up six percent this year, mirroring UUP's performance.

That is not an engraved invitation to buy IWO right now though. IWO allocates 28.2 percent of its weight to health care stocks, the ETF's largest sector weight by 470 basis points over technology. In other words, it is fare to say the bulk of IWO's gains this year are attributable to the run-up in biotechnology stocks, a trade that suddenly looks flimsy. 

As for small-cap value, it has not been much of value this year as the iShares Russell 2000 Value ETF IWN has tumbled 3.4 percent. Remember what Koesterich said about the yield curves impact on small-cap banks and then note IWN's 42.6 percent weight to the financial services sector.