Small-Cap ETFs Experience Turbulence: Can They Recover Momentum Post-Trump’s Election?
The beginning of 2025 has proven to be tumultuous for small-cap stocks. The iShares Russell 2000 ETF (IWM), which tracks the small-cap benchmark index comprising 2,000 small and midsized companies, suffered a notable dip of 3.4% last week. This decline was prompted by stronger-than-expected job data that led to a spike in Treasury yields. This unsettling change fueled speculation that the Federal Reserve might need to pause interest-rate cuts until later in the year, creating a ripple effect across the stock market.
Consequently, investors reacted quickly, pulling out over $871 million from the IWM ETF in the week ending Tuesday, making it one of the three funds with the largest net outflows among over 1,000 ETFs tracked by MarketWatch, according to FactSet data. Nevertheless, the selloff proved short-lived, as a more favorable consumer-price index report led to a strong relief rally for both stocks and bonds. This improvement enabled IWM to achieve its largest daily percentage gain since November 6, moving upwards by more than 3.5% this week and on track to erase earlier losses.
Understanding Small-Cap Movements
According to Philip Greenblatt, portfolio manager at Easterly Investment Partners, much of the volatility within the small-cap index can be attributed to stocks that are highly sensitive to interest rates. Many of these companies carry significant debt and may currently have negative earnings. Consequently, their outlook heavily hinges on a lower discount rate applied to future cash flows. Greenblatt elaborates that as soon as there’s a suggestion of the discount rate decreasing, these stocks tend to surge, prompting investors to flock toward them.
The small-cap landscape is heavily influenced by sectors such as financials and biotechnology, which represent around 25% and 14% of the Russell 2000 index, respectively. Lower interest rates generally bolster the profitability of regional banks, as they reduce interest payments for depositors and lead to increased loan demand. Conversely, biotechnology firms are characterized by their high volatility; their potential for substantial returns is often linked to breakthroughs in clinical trials or innovations in drug development.
Market Outlook: Volatility and Investment Strategy
Greenblatt notes that the pronounced reaction of small caps to economic updates suggests that many investors still regard them as a “one-day trade,” rather than a long-term investment opportunity. “The ideal scenario for small caps is for market participants to take a step back and focus on corporate earnings,” he said. He argues that it would be beneficial to disregard the Federal Reserve’s influence and allow the market to reflect on the fundamental aspects of the rates curve.
In this context, Greenblatt advocates for active management and a value-oriented investment strategy with small-cap stocks, as investors have the opportunity to identify “gems with great balance sheets and real free cash flows as opposed to pure speculation.”
Small Caps and the Trump Effect
The outcome of the 2024 U.S. presidential election heralds a shift in policy expectations, with many investors anticipating that former President Donald Trump’s return to the White House could significantly reshape the investment landscape for small caps. Expectations of tax relief, reduced financial regulations, and increased tariffs fueled a rally in domestically focused smaller companies, pushing the IWM ETF to near-record highs in November. However, that momentum failed to sustain itself, with the IWM closing at levels consistent with its position on November 5.
Portfolio manager Gregory Spiegel of Neuberger Berman expresses an optimistic view despite the recent volatility. He believes the focus on interest-rate cuts is overshadowing the potential for growth driven by the “reindustrialization of America” under the incoming administration, which promotes pro-growth and pro-business policies. He anticipates that small-cap stocks can capitalize on a renaissance of reshoring—bringing supply chains back to the U.S.—which can disproportionately benefit these companies due to their primary domestic revenue generation.
Spiegel contends that the new administration’s policies will empower smaller companies to make more suitable capital-allocation decisions, enhancing their ability to invest in and expand manufacturing capacities, ultimately supporting their earnings and cash flows.
Performance Snapshot of ETFs
As we assess the top and bottom performers over the past week, the following ETFs highlight significant movement:
Top Performers
- 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%
Bottom Performers
- 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%
In conclusion, while small-cap ETFs like IWM faced tumultuous conditions at the start of 2025, the potential for recovery remains as the market adjusts to evolving economic policies and rates. Investors are likely observing closely as the landscape shifts under new leadership.