MW Small-cap ETFs went on a wild ride. Can they regain momentum after Trump takes office?

By Isabel Wang

Hello! This is MarketWatch reporter Isabel Wang, bringing you this week's ETF Wrap. In this edition, we look at small-cap ETFs - which have been on a roller-coaster ride in the first two weeks of the new year - and whether investors should draw cautious optimism in one of the most speculative corners of the market.

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It has been a brutal start to 2025 for small-cap stocks.

The iShares Russell 2000 ETF IWM - which tracks the small-cap benchmark index, composed of 2,000 small and midsized companies in the Russell 3000 index RUA - tumbled 3.4% last week after stronger-than-expected jobs data sparked a big spike in Treasury yields, jarring stocks and prompting investors to consider the possibility that the Federal Reserve may need to pause interest-rate cuts until later this year.

The sharp selloff also triggered a mass exodus from the benchmark small-cap ETF, with investors pulling more than $871 million out of IWM in the week ending Tuesday. It was also one of the three funds that saw the largest net outflows among more than 1,000 ETFs that MarketWatch tracked in the same period, according to FactSet data.

However, investors didn't wait too long for a comeback rally.

On Wednesday, a relatively benign consumer-price index report triggered a sharp relief rally in stocks and bonds, helping IWM score its largest daily percentage gain since Nov. 6. As a result, the fund has advanced over 3.5% this week, on pace to erase all of its decline from earlier this month and heading for its best week in late November, according to FactSet data.

"When you have a large portion of the small-cap index that is super sensitive to interest rates, and they are the companies where earnings may be negative and [they may be] highly indebted, their outlook is highly dependent on a lower discount rate that gets applied to their future cash flows. So anytime those stocks get a hint of that discount rate coming down, they rip [higher] and investors pile into them," said Philip Greenblatt, portfolio manager at Easterly Investment Partners.

Financials and biotechnology firms are two of the larger components of the small-cap landscape, with each representing around 25% and 14% of the Russell 2000 index RUT, respectively, according to FactSet data. In theory, lower interest rates are expected to boost the profitability of regional banks by reducing the interest they pay depositors and triggering an uptick in loan demand. Meanwhile, biotech firms - many of which are involved in the process of developing life-changing medical treatments and technologies - are known for their high volatility in the market, as their potential for significant returns is driven by breakthroughs in clinical trials or drug-discovery processes.

See: Small-cap stocks face heightened risk with rate cuts in question, warns BofA

Greenblatt said the fact that small caps tend to react aggressively to some economic-data releases suggests that most investors still see small caps as a "one-day trade" instead of an investment.

"The best case for small caps is that everybody steps back and just looks at corporate earnings," he said. "It would be great if we just ignore the Fed and take the rate curve for what it is. ... The market needs to break free from its reliance on the Fed."

In Greenblatt's view, small-cap stocks are one area of the market in which active management and value-oriented strategy matters, as investors can find "some gems with great balance sheets [and] real free cash flows, as opposed to gambling."

See: That big one-day stock-market surge we just had? Don't make too much of it.

Small caps set to explode under Trump presidency?

The 2024 U.S. presidential election has ushered in a new era of policy expectations, with investors betting Donald Trump's return to the White House could reshape the investment landscape for small caps by providing tax relief, cutting financial regulations and hiking tariffs.

That's why shares of domestically focused smaller companies surged immediately after the election, with IWM reaching near-record highs in November. However, that rally quickly fizzled out, with IWM ending Thursday at where it settled on Nov. 5, according to FactSet data.

"Do I worry about the [small-cap] volatility over the past two weeks? No - but with the markets being focused on the pace of interest-rate cuts, I think they're missing the bigger picture of the reindustrialization of America under the incoming administration, which is pro-growth, pro-U.S. and pro-business," said Gregory Spiegel, portfolio manager on the small-cap team at Neuberger Berman.

Meanwhile, small-cap stocks are widely expected to benefit from the so-called reshoring renaissance, meaning companies are bringing back their supply chains and returning manufacturing jobs to the U.S.

The return of manufacturing could "disproportionately" benefit smaller companies, because they generate the majority of their revenue domestically versus megacap firms that have much more international exposure, Spiegel told MarketWatch on Thursday.

Spiegel and his team expect the incoming Trump administration's policy agenda will allow smaller companies to "make more appropriate capital-allocation decisions" on where they want to invest and expand manufacturing capacity, and will further support their earnings and cash flows.

As usual, here's your look at the top- and bottom-performing ETFs over the past week through Wednesday, according to FactSet data.

The good...

   Top performers                                                                                                                                                                      %Performance 
   United States Natural Gas Fund LP                                                                                                                                                   11.7 
   United States Oil Fund LP                                                                                                                                                           9.1 
   YieldMax MSTR Option Income Strategy ETF                                                                                                                                            7.4 
   iShares Bitcoin Trust ETF                                                                                                                                                           6.2 
   Grayscale Bitcoin Mini Trust ETF                                                                                                                                                    6.1 
   Source: FactSet data through Wednesday, Jan. 15. Start date Jan. 8. Excludes ETNs and leveraged products. Includes NYSE-, Nasdaq- and Cboe-traded ETFs of $500 million or greater. 

... and the bad

   Bottom performers                          %Performance 
   ARK Genomic Revolution ETF                 -4.5 
   SPDR S&P BIOTECH ETF                       -4.1 
   iShares MSCI India Small Cap ETF           -3.9 
   YieldMax NVDA Option Income Strategy ETF   -2.8 
   Invesco Solar ETF                          -2.7 
   Source: FactSet data 

New ETFs

-- Infrastructure Capital Advisors on Wednesday announced the launch of the Infrastructure Capital Bond Income ETF BNDS, which aims to achieve high yield by investing at least 80% of its total assets in fixed-income securities, the company said in a press release.

-- Leverage Shares by Themes on Tuesday announced the expansion of its leveraged, single-stock ETF lineup with the launch of the Leverage Shares 2X Long ASML Daily ETF ASMG, the Leverage Shares 2X Long ARM Daily ETF ARMG and the Leverage Shares 2X Long TSM Daily ETF TSMG.

-- Simplify Asset Management on Tuesday launched the Simplify China A Shares PLUS Income ETF CAS, an actively managed fund that is designed to provide exposure to small-, mid- and large-cap Chinese mainland-listed companies utilizing an options overlay, the firm said in a press release.

-- BlackRock on Thursday announced the launch of the iShares Large Cap Accelerated ETF TWOX, which employs an options strategy that seeks to provide investors approximately twice the upside price return of the iShares Core S&P 500 ETF IVV up to an approximate cap, while aiming to approximately track the downside price return of IVV when held for an entire outcome period.

Weekly ETF Reads

-- Bond ETFs are down in 2025 ahead of highly anticipated U.S. inflation data (MarketWatch)

-- Why S&P 500's financials sector just booked its best day since early November (MarketWatch)

-- More Crypto ETFs Are Almost Certainly Coming Under Trump (Barron's)

-- JPMorgan Says Altcoin-ETF Inflows May Be as High as $14 Billion (Bloomberg)

-- Asset managers turn to defensive positioning as equity prices soar (Financial Times)

-Isabel Wang

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January 16, 2025 19:08 ET (00:08 GMT)

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