US small cap ETFs losing steam as GDP growth disappoints

Mar 1st, 2017 | By | Category: Equities

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One of the biggest winners after the US presidential election were small-cap equities, yet small-cap US ETFs have lost out to their large-cap counterparts so far this year as GDP growth has fallen short of expectations.

US small cap ETFs losing steam as GDP growth disappoints

The US saw annualised GDP growth of 1.9% in the last quarter of 2016, falling short of expectations of 2.1%.

ETFs tracking the Russell 2000 Index benefited significantly after the election on 8 November, as the index recorded its longest rally in 20 years – it rose close to 9% in the month after the election, beating the S&P 500 and the Dow Jones Industrial Average.

US small-cap ETFs have also outperformed their large-cap equivalents over the medium term; the $504.7 million SPDR Russell 2000 US Small Cap UCITS ETF (LON: R2US) is up 36.7% over the last 12 months in USD terms, compared to the 23.2% return for the $18 billion Vanguard S&P 500 UCITS ETF (LON: VUSD) over the same period.

It is a different story so far in 2017. R2US is only up 2.4% year to date, compared to VUSD’s 5.4% in the same timeframe.

There are several reasons for the diverging performance. In 2016, Trump promised to increase spending on infrastructure, cut regulations and reform taxes to boost economic growth and create more jobs. Consequently US stocks, particularly smaller ones, were boosted by the nationalist “America First” mantra.

Small caps generate most revenue from the domestic market (constituents of the Russell 2000 Index on average pull in approximately 20% of their income from foreign markets), whereas the S&P 500 companies gain around a third of revenue from overseas exposure. Any slowdown in global growth, or uncertainty surrounding politics and economics overseas, would be slower to impact small stocks.

Investors should also note that the US saw annualised GDP growth of 1.9% in the last quarter of 2016, which fell short of expectations of 2.1%. This is likely to have had a relatively stronger impact on the price of US small-cap equities as investors priced in the impact of lower expected corporate earnings growth.

Data from the Bank of America Merrill Lynch found that small-cap earnings actually declined by about 1% year-on-year in the final quarter of 2016 compared with growth of 6% for large-caps over the same period.

Small caps also appear to have stretched valuations: BaML analysts compared them to those seen during the tech bubble of the late 1990s, as reported by the Financial Times. The Russell 2000 Index is trading around 19x forward earnings, higher than its long-term median of 15.2x.

The S&P 500 is trading around 18.6x forward earnings, which is also described as a relatively high valuation.

After years of low interest rates, smaller stocks have also chalked up relatively large piles of debt, which could become burdensome if rates are hiked. While large-caps have also increased their debt burden, greater access to credit compared to small-caps lowers the risk of these firms entering significant financial difficulty.

The US dollar also appears to be ending its multi-year bull run, being down about 2.6% against a basket of currencies in January. The performance was described as the currency’s worst start to a year since 1987. Large-cap stocks may receive greater benefit from a lower dollar environment due to a greater share of revenues being derived from foreign markets.

For investors who still believe small-cap stocks will outperform large-caps again, there are five ETFs listed in Europe that track the Russell 2000 Index, including R2US, which is the largest in terms of assets and the cheapest at 0.30% fees. The fund is very well diversified with 1,371 holdings. It has 27.5% in financial services, 14.6% in technology and 13.8% in “producer durables” i.e manufacturers of durable goods.

Another cheap option for 0.30% is the $86.8m SPDR MSCI USA Small Cap Value Weighted UCITS ETF (LON: USSC) which is up 1.8% year to date and a whopping 36.2% over 12 months. The ETF’s underlying index, the MSCI USA Small Cap Value Weighted Index, uses a smart beta weighting methodology to tilt the parent MSCI USA Small Cap Value Index to stocks with lower valuations. Each constituent of the parent index is reweighted according to four fundamental accounting variables: sales, book value, earnings and cash earnings. It tracks 1,251 stocks which are screened for low valuation characteristics, with 21.4% in financials, 16.8% in industrials and 13.7% in consumer discretionary stocks.

The ETF may be suitable for investors who are seeking exposure to US small-cap stocks but are concerned the market may be trading at a relatively expensive valuation.

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