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The U.S. dollar continues to rally against a basket of major currencies following Fed chair Janet Yellen’s speech at Jackson Hole on last Friday, which increased the chances of a sooner-than-expected rate hike. Moreover, an expected impressive recovery in the third quarter despite dismal second quarter GDP growth also led the U.S. dollar to surge recently.

The surge is expected to have a negative impact on stocks and ETFs with large international exposure. Hence, it may be prudent to invest in small cap ETFs that are likely to have lesser international exposure and thus insulated from the effects of a rising dollar.

Surging U.S. Dollar

The U.S. Dollar Index (DXY), that seeks to track the performance of dollar against six major currencies, reached its highest level of 96.143 since Aug 9 on Tuesday. The index ended the day at 96.062, rising 0.5%. The U.S. dollar jumped 1.1% against the Japanese currency to 103.01 yen. During the day, the greenback reached the highest level of 103.13 yen since Jul 29. The euro also suffered against greenback on Tuesday by declining to $1.1138.

CurrencyShares Euro ETF (FXE - Free Report) , which seeks to reflect the price in USD of the Euro, declined 0.4% yesterday and also lost nearly 1.1% over the past one week. Separately, a strengthening U.S. dollar is leading the greenback tracking ETFs to gains in recent times. PowerShares DB US Dollar Bullish ETF (UUP - Free Report) and WisdomTree Bloomberg US Dollar Bullish ETF (USDU - Free Report) gained 0.6% and 0.7% yesterday, respectively. UUP and USDU also registered gains of 1.4% and 1.3% respectively, over the past week (read: ETF Winners & Losers Post Jackson Hole Meet).

Rising Rate Hike Chances Drive Dollar Higher

Janet Yellen’s speech at Jackson Hole, along with comments from some of the major Fed officials in recent times raised speculations of a hike by the end of this year, which played a major role in boosting the greenback. The Fed chair said: “In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months.”

Among others, Fed’s vice chair Stanley Fisher said in an interview that the central bank “choose [s] the pace [rate hike] on basis of data… employment is very close to full employment.” While San Francisco Fed President John Williams said that it is appropriate “to get back to a pace of gradual rate increases, preferably sooner rather than later,” Atlanta Fed President Dennis Lockhart favored “at least one increase of the policy rate” by the end of this year (read: Is it Time to Invest in Financial ETFs?).

Improving Economy Likely to Boost Greenback Further

Despite disappointing second-quarter GDP growth, recently released data indicated that the economy is on a track to post solid rebound in the third quarter. Though the second-quarter GDP growth rate was revised downward in “second estimate” of the Bureau of Economic Analysis (BEA), the surge in consumer spending during the quarter was one of the few bright spots in the report.

While consumer expenditure surged at the fastest rate since the last quarter of 2014 during the quarter, personal consumption expenditures rose for the fourth-consecutive month in July. Meanwhile, the Conference Board reported yesterday that Consumer Confidence Index rose to 101.1 in August, hitting the highest level in the last 11 months. The reading also came higher than the consensus estimate of 97.4.

Moreover, the outlook for the second half of this year also remains positive. According to Yellen, the Fed “expects moderate growth in real gross domestic product, additional strengthening in the labor market, and inflation rising to 2% over the next few years.” Separately, the Atlanta Fed now projects third-quarter GDP of 3.4%, significantly higher than the sluggish first and second quarter growth rates.

3 Small-Cap ETFs to Buy

Investing in small cap securities looks to be an ideal proposition in the current backdrop. Small-cap stocks are closely tied to the domestic economy and generate most of their revenues from the domestic market and thus are poised to get less affected by a surge in the U.S. dollar and sluggish growth in global economy. Moreover, due to their heavy domestic exposure, these stocks are expected to outperform when the American economy is expected to witness robust improvement (read: Why Small-Cap Value ETFs Are Winning Picks Now).

Hence, we have highlighted three small-cap ETFs, investing in which may boost one’s portfolio in improving economic scenario, while protecting the same from getting affected by strengthening dollar. These ETFs also carry Zacks ETF Rank #2 (Buy) with a Medium outlook, indicating upside potential (see all small-cap ETFs here).

iShares S&P Small-Cap 600 Value (IJS - Free Report)

The fund looks to provide exposure to U.S. small-cap value stocks by tracking the S&P SmallCap 600 Value Index. The $4 billion fund holds a total of 457 small cap stocks. The fund appears diversified as no stock accounts for more than 1% of the basket.  Among the different sectors, Financials, Industrials, Consumer Discretionary and IT occupy the top four positions with 22.4%, 18.7%, 16.1% and 15.3% of weight, respectively. The fund charges a premium of 25 basis points annually and trades at an impressive volume of nearly 236,000 shares a day. The ETF gained 7.4% in the past three months and has added 1.9% over the past one-month period.

Schwab Fundamental US Small Company ETF (FNDA - Free Report)

DES looks to track the performance of the Russell Fundamental U.S. Small Company Index. The fund has about $966.3 million in AUM and a daily average trading volume of around 126,000. It charges 32 bps in fees. Holding more than 910 stocks in its basket, the product puts about 4% of its total assets in the top 10 holdings, suggesting low concentration risk. Sector wise, this ETF is heavy on industrials (20%) followed by consumer cyclical (15%), technology (14%) and financials (13%). The fund returned 1.4% and 5.8% over the past one-month and three-month time frames, respectively.

Vanguard S&P Small-Cap 600 Value ETF (VIOV - Free Report)

This fund provides exposure to the value segment of the U.S. small cap market by tracking the S&P Small-Cap 600 Value Index. It holds a large basket of 457 stocks, which is widely spread across individual securities as only 8.6% of its assets get invest in top ten holdings. In terms of sector exposure, financials dominates the portfolio at 22.2%, followed by industrials (18.8%) and consumer discretionary (16.3%). The ETF has AUM of $126.5 million and trades at a light volume of nearly 6,000 shares a day. It charges 20 bps in fees per year from investors. The ETF returned 7.4% in the past three months and has added 2% over the past one-month period.

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