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Are Small-Cap ETFs in Trouble?

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After hitting a peak in mid-February, the Wall Street tumbled into a bear market in less than a month, triggered by the COVID-19 outbreak. Though the decline was broad-based, small-cap stocks fared worse than their large- and mid-cap counterparts.

The ultra-popular iShares Russell 2000 ETF (IWM - Free Report) has plunged nearly 35% so far this year, compared with loss of 21.3% for large cap ETF, SPDR S&P 500 ETF Trust (SPY - Free Report) , and 33.1% for mid-cap ETF, iShares Core S&P Mid-Cap ETF (IJH - Free Report) . The pandemic has resulted in lockdowns and forced people to stay indoors to contain the spread that is weighing heavily on economic growth and business activity (read: ETFs Set to Benefit from Social Distancing, Stay-At-Home).

Layoffs and jobless claims have risen unprecedentedly with businesses scaling back or temporarily shutting down their operations. Spending — the engine of the U.S. economy — has collapsed. Revenues of restaurants, hotels, movie theaters, gyms, and airlines have been badly hit with many of them on the brink of bankruptcy. Amid mass closures of private businesses, soaring layoffs and shutdowns, market participants forecast global recession in the coming quarters.

ETFs That Tumbled the Most

While every corner of the small cap space has declined, we have highlighted the worst- performing ETFs. These are not confined to a particular sector or industry but offer broad exposure to small-cap securities. Invesco S&P SmallCap 600 Pure Value ETF (RZV - Free Report) emerged as the biggest loser, tumbling 53.3% so far this year. It provides exposure to stocks that exhibit strong value characteristics in the S&P SmallCap 600 Index. The fund has a Zacks ETF Rank #3 (Hold).

First Trust Small Cap Value AlphaDEX Fund (FYT - Free Report) , Invesco S&P SmallCap High Dividend Low Volatility ETF (XSHD - Free Report) and WisdomTree US SmallCap Earnings ETF (EES - Free Report) shed nearly 45% each. FYT also targets the value corner of the small-cap space but employs the AlphaDEX stock selection methodology to select stocks from the NASDAQ US 700 Small Cap Value Index. XSHD offers exposure to the stocks that have historically provided high dividend yields with lower volatility over the past 12 months while EES provides broad U.S. small cap equity exposure to profitable companies. FYT and EES have a Zacks ETF Rank #3 (read: Short Small-Cap ETFs as U.S. May Face Technical Recession).

PGIM QMA Strategic Alpha Small-Cap Value ETF , First Trust Dow Jones Select MicroCap Index Fund (FDM - Free Report) , Invesco S&P SmallCap 600 Revenue ETF (RWJ - Free Report) and iShares S&P SmallCap 600 Value ETF (IJS - Free Report) were down more than 40% each.

What Lies Ahead?

More pain seems to be in store for small-cap stocks than their large-cap peers, given that the pandemic has hurt the domestic economy. The latest bouts of data paint a gloomy picture of the economy for the near term.

New jobless claims doubled to 6.648 million for the week ended Mar 28, representing unprecedented spike for the second consecutive week. Unemployment claims jumped to a record high of 3.28 million in the week ended Mar 21. In total, more than 10 million Americans have filed for unemployment over the past two weeks. Meanwhile, the manufacturing sector contracted in March with activity hitting its lowest level since 2009 while consumer confidence dropped to a near three-year low last month (read: ETFs to Suffer as March's ISM Manufacturing Index Disappoints).

Further, President Donald Trump has warned “very, very painful two weeks” in face of the rapidly spreading disease. The White House projects that the coronavirus pandemic could claim 100,000 to 240,000 lives, even if current social distancing guidelines are maintained. United Nations stated that the outbreak is the “most challenging crisis we have faced” since World War II. As the pint-sized stocks are closely tied to the U.S. economy and do not have much exposure to the international market, these stocks generally underperform on deteriorating American economic health (read: Prepare for 'Painful Two Weeks' With 5 ETF & Stock Strategies).

With the economic fundamentals worsening, one Bank of America analyst predicts the deepest recession on record, nearly five times more severe than the post-war average. It expects U.S. GDP to contract for three consecutive quarters with a cumulative decline of 10.4%, job losses of as many as 20 million, and unemployment rate to go high as 15.6%. Another analyst at JP Morgan recently slashed first-half GDP growth estimates with first-quarter growth down to -10% from -4% and second quarter estimates to -25% from -14%. Unemployment was projected to be as high as 8.5%.

However, the large fiscal and monetary stimulus is expected to provide a boost to the economy that will benefit the domestically focused companies the most. The House of Representatives last week approved a historic $2.2 trillion stimulus package to rescue the economy ravaged by the coronavirus.

The new deal added to aggressive action announced by the Federal Reserve in recent days. After slashing interest rates to near zero and offering to buy more government bonds and mortgage-backed securities as needed to support smooth market functioning, the Fed will now lend against student loans and credit card loans, as well as back the purchase of corporate bonds and direct loans to companies. This represents the most extreme intervention in the economy by the central bank in its history of more than 100 years (read: ETFs to Gain as Wall Street Cheers US Stimulus Package).

Given the solid long-term outlook but somewhat bearish near-term sentiments, investors may want to stay on the sidelines for the time being. However, risk-tolerant long-term investors may want to consider this recent slump a buying opportunity, should they have the patience for extreme volatility.

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