Hopes of tax reform have restored the fortunes of small cap stocks that were lagging in the first half of the year as Trump’s pro-growth policies stalled or got stuck in a political gridlock. The optimism elevated following the Senate’s approval of the biggest U.S. tax overhaul in three decades. Republicans are now closer to finalizing the $1.5-trillion tax reform by the end of the year, though the version of the passed House bill differs on some fronts.
Small caps with a median effective tax rate of 31.9% are the biggest beneficiaries of Trump’s tax cut plans. In comparison, the larger, multi-national companies on the S&P 500 pay a lower median effective tax rate of 28% while the tax rate for 30 mega-cap stocks on the Dow Jones Industrial Average is even lower at 23.8% (read: 4 Sector ETFs & Stocks Set to Explode Higher on Tax Cuts). Further, the U.S. economy is booming with back-to-back quarters of an unrealistic 3% growth, 17-year high consumer confidence and the lowest level of unemployment of 4.1% since December 2000. Against such a backdrop, small-cap stocks have led the way higher as these are closely tied to the U.S. economy and do not have much exposure to the international market. These pint-sized stocks generate most of their revenues from the domestic market and generally outperform on improving American economic health. These are also free from the clutches of any political malaise. Moreover, after hiking rates in December 2015 and December 2016, the Fed has raised interest rates two times this year and looks to hike rates again this month. This indicates a stronger economy and propels small-cap stocks higher. Honing in on growth securities in this capitalization level allows investors to earn more returns. Growth investing is basically a momentum play, which makes it a great strategy in a trending market (i.e. a market characterized by a prolonged uptrend). Stocks in the growth ETF portfolio harness their momentum in earnings to create a positive bias in the market, resulting in rocketing share prices. As such, growth funds tend to outperform during an uptrend. Given this, investors could smartly ride out the current trends through a number of small-cap growth ETFs. For them, we have narrowed down the list of ETFs by using the Zacks ETF Rank. This system looks to take into account a variety of factors, such as industry outlook and expert surveys, and then apply ETF-specific factors (like expense ratios and bid/ask spreads) to find the best funds in each segment. Using this system, we have found a handful of ETFs that have a Zacks ETF Rank of 1 or ‘Strong Buy’, and are thus poised to outperform in the months to come (see: Our Zacks ETF Rank Guide). In fact, several small-cap funds in have seen their Zacks Rank moving to the top hierarchy from #3 (Hold) that could make great holiday picks. Vanguard Small-Cap Growth ETF ( VBK Quick Quote VBK - Free Report) This ETF tracks the CRSP US Small Cap Growth Index, holding 675 securities in its basket. The fund is widely diversified across a number of sectors and securities. Industrials, financials, technology, health care, and consumer services make up for double-digit allocation each and none of the securities holds more than 0.7% of total assets in the basket. The product has amassed $6.8 billion in its asset base while trades in solid volume of around 111,000 shares. VBK charges 7 bps in fees per year and is up 7.9% in the past three months (read: ETFs to Benefit from Trump Tax Plan). iShares S&P Small-Cap 600 Growth ETF IJT This fund follows the S&P SmallCap 600 Growth Index and holds a well-diversified portfolio of 353 stocks, with each security making up for no more than 1.2% of assets. Further, it is well spread across various sectors with industrials, information technology, healthcare, financials, and consumer discretionary accounting for a double-digit allocation each. IJT has AUM of $4.9 billion and average trading volume of 95,000 shares. Expense ratio comes in at 0.25%. The fund has gained 10.1% in the last three months. Vanguard S&P Small-Cap 600 Growth ETF VIOG The ETF tracks the S&P Small-Cap 600 Growth Index. Holding 355 securities, the fund is well spread out across each security with none holding more than 1.5% of assets. Information technology, industrials, healthcare, financials and consumer discretionary are the top five sectors with double-digit allocation each. The product has managed $303 million in AUM and volume is rather weak at just 7,000 shares, suggesting additional cost beyond the expense ratio of 0.20%. The ETF has added about 10.2% in the past three months (see: all the Small Cap ETFs here). Bottom Line These ETFs have emerged leaders in the current broad market rally, easily outpacing the broad market fund SPY. Given the extremely bullish trend in the small cap space and the holiday fervor, investors should definitely look at these ETFs or some other funds that have recently seen their Rank surging to #1. Want key ETF info delivered straight to your inbox? Zacks’ free Fund Newsletter will brief you on top news and analysis, as well as top-performing ETFs, each week. Get it free >>