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After The Recent Pullback, Are Small Cap ETFs A Buy Or A Sell?

From Zacks: After outperforming the broader market in November and December on Trump’s victory, small cap stocks have lost their luster this year.

This is especially true as the ultra-popular small-cap ETF (IWMFree Report) , with an asset base of around $37.8 billion and an average daily volume of around 29.9 million shares, has seen a huge outflow of more than $1.8 billion this year after pulling in $7.2 billion in capital in the last two months of 2016.

IWM has been lagging this year rising just 2.1% compared with gains of 4% for the mid-cap counterpart (IJHFree Report) and 5.9% for the large-cap cousin (SPYFree Report) . The delay in the implementation of Trump’s domestic pro-growth policies, the travel ban debacle, overhaul of the Affordable Care Act, shift in investors’ sentiment and Fed rate hike concerns have weighed heavily on the pint-sized stocks (read: Profit from the Trump Bump with Volatility ETFs).

In addition, fourth-quarter earnings for companies in the small-cap S&P 600 space were unimpressive with an earnings decline of 1% compared with growth of 7.8%, as per Thomson Reuters. Analysts expect earnings growth for the S&P 600 in the first quarter of 2017, but at a rate well below that of the S&P 500. Further, the surge in small caps post election has made these stocks expensive. The S&P 600 and the Russell 2000 index have a forward P/E ratio of 20.4 and 25.4, respectively, versus 17.8 for the S&P 500.

Investors should note that economic expansion prompted by Trump’s win and Fed’s monetary policy are the two major driving forces of the small cap stocks performance.

Trump and Fed: Game Changers

Trump’s proposed stimulus policies, including big time spending on infrastructure, reduced regulations, and lower corporate taxes, when enacted should benefit small caps more as these are closely tied to the U.S. economy and generate most of their revenues from the domestic market. Additionally, the President “America First” proposals favor small cap companies relative to mega-caps that derive a significant portion of sales outside the U.S. (read: Trump Unveils First Budget Blueprint: ETFs to Gain or Lose).

Small cap stocks generally outperform when the American economy is leading the way. Since these companies are small, they are poised to grow more than their already tapped out large-cap counterparts.

Further, Trump’s proposed renegotiation or the termination of the North American Free Trade Agreement and building of a Mexico wall would favor small-cap stocks in case it results in a trade war or a tariff increase as expected.

The Fed increased interest rates this month for the third time in a decade, indicating a stronger economy and in turn propelling small cap stocks higher. The dovish tone on the future pace of rate hike is also positive for these stocks, which tend to get hit hard when borrowing costs increase (read: See How ETFs React When Hawks Act Like Doves).

Top-Ranked Small Cap ETFs in Focus

Given improving near-term trends, investors could consider building positions in the small cap ETFs. For them, we have found a number of ETFs that have a top Zacks ETF Rank of 1 or ‘Strong Buy’ rating in the small cap space and are thus expected to outperform in the months to come (read: all the Top Ranked ETFs).

In fact, we have highlighted five ETFs that recently sported a Zacks Rank #1 in the latest rating upgrade from 3 or ‘Hold’ rating. These funds have potentially superior weighting methodologies that could allow these to continue leading the small cap space in the months ahead.

Vanguard Small-Cap ETF (VBFree Report)

The fund follows the CRSP US Small Cap Index and holds a basket of 1429 stocks with none holding more than 0.4% of assets. Financials dominates the portfolio at 27.3%, followed by industrials (19.9%) and technology (11.6%). The ETF is popular with AUM of $18.9 billion and trades in solid average daily volume of about 234,000 shares. VBK is one of the low cost choices, charging just 8 bps in fees per year from investors. It has added 3.5% so far this year.

iShares Russell 2000 Growth ETF (IWOFree Report)

This is also one of the popular and liquid ETFs in the small cap space with AUM of $7.7 billion and average trading volume of 29.9 million shares a day. The fund provides exposure to a broad basket of 1,164 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 0.64% of assets. Sector wise, information technology and health care take the top two spots with a combined share of nearly 48%, leaving a decent allocation for the others. The fund charges 25 bps in annual fees from investors and has gained over 5% this year (read: Trump Sets Bullish Tone: Grab These Top-Ranked ETFs).

Vanguard Small-Cap Growth ETF (VBKFree Report)

This ETF tracks the CRSP US Small Cap Growth Index, holding 675 securities in its basket. The fund is widely diversified across a number of sectors and securities. Financials, industrials, health care, technology, and consumer services make up for double-digit allocation each and none of the securities holds more than 0.7% of total assets in the basket. The product has amassed $6.2 billion in its asset base while trades in solid volume of around 234,000 shares. VBK charges 8 bps in fees per year and is up 5.7% in the year-to-date timeframe.

iShares S&P Small-Cap 600 Growth ETF (IJTFree Report)

This fund follows the S&P SmallCap 600 Growth Index and holds a well-diversified portfolio of 348 stocks, each security making up for no more than 1% of assets. Further, it is well spread across various sectors with industrials, financials, information technology, healthcare, and consumer discretionary accounting for a double-digit allocation each. IJT has AUM of $4.4 billion and average trading volume of 197,000 shares. Expense ratio comes in at 0.25%. The fund has added 2.5% so far this year (see: all the Small Caps ETFs here).

SPDR S&P 600 Small Cap Growth ETF (SLYGFree Report)

This fund tracks the S&P SmallCap 600 Growth Index, holding 350 stocks in its portfolio. SLYG is also well diversified with none holding more than 1% of assets and industrials, financials, information technology, healthcare, and consumer discretionary accounting for a double-digit allocation each. The ETF has been able to manage $1.2 billion in its asset base while trades in a lower volume of 34,000 shares a day on average. It charges 15 bps in annual fees and has gained 2.5% in the year-to-date timeframe.

The iShares Russell 2000 Index ETF (NYSE:IWM) was trading at $133.22 per share on Wednesday morning, down $0.75 (-0.56%). Year-to-date, IWM has declined -1.21%, versus a 4.33% rise in the benchmark S&P 500 index during the same period.

IWM currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 28 ETFs in the Small Cap Blend ETFs category.

This article is brought to you courtesy of Zacks Research.

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