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Why Leveraged Small-Cap ETFs Are Going Through the Roof

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Small-cap stocks have been painting the town red this year, outshining large-caps, as is evident from the 5% year-to-date gains from iShares Russell 2000 ETF (IWM - Free Report) versus a 1.2% rise in the large-cap fund SPDR S&P 500 ETF (SPY - Free Report) . The ascent is more prominent this month as the Russell 2000 touched an all-time high.

The Russell 2000-based fund IWM has gained about 4.9% so far this month (as of May 17, 2018) versus about 2.7% of SPY. Needless to say, such a rally in pint-sized stocks boosted the leveraged small-cap funds in recent sessions. ProShares UltraPro Russell2000 (URTY - Free Report) is up 14.6% in the month-to-date frame (as of May 17, 2018).

A host of factors are backing this small-cap rally. Let's find out what these are.

Chances of Faster Fed Rate Hikes & Stronger Dollar

The Fed has enacted a hike in March and is expected to enact two more in 2018, of which the second is expected at the next policy meeting in June. Traders have priced in a 100% chance of a June rate hike and in fact 54% chance of three more U.S. rate hikes this year. This has pushed up the benchmark Treasury yield to a 7-year high of 3.11% as on May 17, 2018 (read: ETF Strategies to Play the 7-Year High Benchmark Yield).

All these are working in favor of the greenback. PowerShares DB US Dollar Bullish ETF (UUP - Free Report) was up 4.6% in the past month (as of May 17, 2018). This makes investing in small-caps profitable as these generate most of the revenues from the domestic market and are less affected by negative currency translation.

U.S. Economy Better Positioned in the Globe

Economic well-being at the domestic land is seen as beneficial for small-cap stocks. The first reading of the U.S. GDP for the first quarter of 2018 advanced at a 2.3% annual rate of growth, above market expectations of 2%. The labor market is steady and retail sales have been in great shape in the United States (read: U.S. Retail Sales in the Pink: ETFs & Stocks to Play).

On the other hand, Europe is showing a slowdown. Japan is struggling to boost inflation. Emerging market currencies are facing troubles on a surging dollar. U.S.-China trade tensions have not been resolved yet. Against this backdrop, it makes sense to limit international exposure and stick to small-cap stocks (read: What European Slowdown? Here Are 4 ETFs Beating S&P 500).

Tax Reform Should Favor Small Caps Over Large Caps

The tax reform or tax cuts are yet another boon to the segment. The move is likely to favor small-caps more. "Companies in the small-cap Russell 2000 pay a median effective tax rateof 31.9 percent , while the larger, multinational companies in the S&P 500 pay a median effective tax rate of 28 percent," per Thomson Reuters data.

Upbeat Earnings

Per Earnings Trends issued on May 17, 2018, 88.5% of stocks in the small-cap S&P 600 index have come up with their earnings. Total earnings for these companies went up 21.4% on 9.7% higher revenues, with 60.5% beating EPS estimates and 72.2% beating revenue estimates. Plus, revenue surprises are especially tracking above historical periods. For the overall Q2, total S&P 600 earnings are expected to surge 18.2% on 9.8% higher revenues.

Leveraged Small-Cap ETFs in Focus

The bullishness has resulted in huge gains for leveraged small-cap ETFs as investors seek to register big gains in a short span. Leveraged funds provide multiple exposure (i.e. 2x or 3x) to the daily performance of the underlying index.

Below, we have highlighted a few ETFs that have been on a tear in the past month (as of May 17, 2018).

Direxion Daily Small Cap Bull 3X Shares (TNA - Free Report) – Up 9.7%

ProShares UltraPro Russell 2000 (URTY - Free Report) – 7.5%

ProShares Ultra SmallCap600 (SAA - Free Report) – Up 5.8%   

ProShares Ultra Russell2000 (UWM - Free Report) – Up 5.0%

Direxion Daily Small Cap Bull 2x Shares (SMLL - Free Report) – Up 4.6%

Word of Caution

While this strategy will prove profitable for short-term traders, it could lead to huge losses compared to traditional funds in fluctuating or seesawing markets. Further, their performances could vary significantly from the actual performance of the underlying index over a longer period when compared to the shorter period (such as, weeks or months) due to their compounding effect (see: all Leveraged Equity ETFs here).

Still, for ETF investors who are bullish on small-cap equities for the near term, any of the above products could make an interesting choice. Clearly, these products are for investors with a strong stomach for risks.  

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