6 Top Small Cap ETFs Built For The Economic Recovery

Cyclicals, value stocks and emerging markets look well-positioned to outperform from here.
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As vaccines continue to get distributed and businesses begin returning to normal, there's a high degree of confidence that we're getting close to a return to our pre-pandemic lives. Areas of the market that were particularly hard hit by COVID, such as real estate, leisure & hospitality businesses and cyclical sectors, have been recovering nicely and the Fed is taking all the necessary (and unnecessary) steps to ensure this economic rebound doesn't hit any snags.

That doesn't mean there aren't some risk areas still out there. The jobs market is still showing some weakness as enhanced unemployment benefits keep many workers on the sidelines, vaccination rates in many regions worldwide are still far behind those of the United States and Europe is still catching up on the growth trajectory.

With the global growth narrative intact, however, and the Fed likely to keep pushing this train along, conditions are favorable for another leg higher in risk assets during the 2nd half of 2020. While there's a chance that a full scale recovery might arrive later than expected, if we look at things from a 30,000 foot view, the world will emerge from recession, likely at some point over the next 12 months, and investors will probably remain bullish in the meantime.

That's a good thing for small-caps, which strongly outperformed in the immediate aftermath of the COVID bear market bottom, but have since retreated as the timeline of the recovery becomes more uncertain.

IWM vs. SPY

IWM vs. SPY

We know that, generally speaking, economic expansions tend to favor three major groups - small caps, cyclicals and value stocks. We've seen these trades gain steam over the past year and it seems reasonable to think there's still a long way to go for these trades to catch up.

If you're looking to tilt your portfolio to outperform during a cyclical recovery, here are 6 small-cap ETFs to help you out.

iShares Russell 2000 ETF (IWM)

Let's start with a simple all-encompassing small-cap ETF. Small-caps should, in theory, outperform large-caps over time given their faster growth nature and risk premium involved. Over the past 17 years, however, small-caps are still underwater relative to large-caps. In my opinion, there's still a lot of catching up to do for small companies and an accelerating recovery could be the catalyst to set it in motion.

The Russell 2000 also has the advantage of being more diversified than the tech and growth heavy S&P 500. Tech only accounts for 12% of the index, while healthcare, financials and industrials own the top 3 sector allocations. That's going to be a comparatively better setup for an economic recovery environment.

Invesco S&P SmallCap Financials ETF (PSCF)

Financials have a couple of things going for it right now. Keep in mind that only about 25% of stimulus cash is getting spent right now as most of it is either being saved or used to pay down debt. A continued recovery will get people into an improved financial situation and that should increase spending and get people borrowing again. On top of that, higher interest rates, which could come via the recovery or through higher inflation, would improve bank margins and profitability.

PSCF, which focuses on smaller, regional financials, could be in the best position to benefit. Since its September low, the fund is up 70%.

Invesco S&P SmallCap Value with Momentum ETF (XSVM)

The value-over-growth trade has also been in place since around September. Small-cap value has been one of the worst performing groups for years, but that's beginning to change as well. The group has been significantly outperforming small-cap growth since February as recovery trades remain in favor and I expect this trend to continue.

The addition of momentum to this small-cap value portfolio is a nice twist. Investors often associate momentum with growth, but that's no longer the case. The iShares MSCI USA Momentum Factor ETF (MTUM) just rebalanced and is now tilted heavily towards value and cyclical names. XSVM already has a 40% allocation to the combination of financials & industrials and I suspect that cyclical lean will only get larger at its next rebalance.

Principal U.S. Small-Cap Multi-Factor ETF (PSC)

PSC starts out with a broad U.S. small-cap starting universe and layers on several criteria to identify the best of the best. From that universe, it targets companies that exhibit the best combinations of high quality, low volatility, quality, value, momentum and shareholder yield. Overall, the fund tilts towards the small-cap value style box, but the fund is really pulling names from the entire space.

A multi-factor ETF is never a bad idea to consider since they tend to favor well-run, cash-rich companies, but the fact that PSC ends up with overweights in both value stocks and dividend payers gives it a good chance to outperform during the recovery.

Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)

It would be a mistake to only consider U.S. small-cap ETFs. International stocks have pretty consistently lagged U.S. stocks for the past decade, but the boat could finally be getting ready to turn. The weaker dollar has provided a tailwind to international investments and it's well-known that equities from developed foreign markets and especially emerging markets are considerably cheaper than U.S. stocks.

That in and of itself doesn't mean they're a buy, but given that many of these regions are behind the curve on both the economic recovery front and the COVID vaccination and recovery front, there could be better growth opportunities ahead. Emerging markets are expected to experience the greatest growth over the next two years and with a 25% allocation to this group within the all-world portfolio, it offers another high growth boost.

WisdomTree Emerging Markets Small Cap Dividend ETF (DGS)

This is obviously the emerging markets only version of an international small-cap fund, but there are a few factors that make DGS potentially more attractive for a recovery. Its focus on dividend payers within the small-cap universe means you get more high quality companies and a dividend yield of more than 3%. It's more diversified with 8 different sectors maintaining allocations of 8% or more of fund assets. It's much less tech-heavy than the S&P 500 and much less China-heavy than other emerging markets indices (about 12% in this fund vs. 34% for emerging markets in general).

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