VTWO - IWM: Small Caps Are Back In The Danger Zone

2023-10-16 09:00:15 ET

Summary

• Small caps have struggled due to high interest rates and weak fundamentals. They have continued to suffer from underperformance against the S&P 500.
• The Russell 2000 is relatively well-diversified. However, most companies in the index aren't assessed to have sustainable competitive advantages.
• Intensifying geopolitical risks and adverse market conditions suggest caution for the Russell 2000. I explain why I anticipate small caps to continue underperforming in the near term.

Small caps have continued to suffer under the weight of elevated interest rates and relatively weak fundamentals, as seen in the stock represented in the Russell 2000 Index ( RTY ). Given its familiarity with investors, investors keen on small-caps investing can consider using iShares Russell 2000 ETF ( IWM ) as a conduit.

IWM is an ETF designed to " track the investment results of an index composed of small-capitalization US equities." Based on the fund manager's latest update, it has an expense ratio of 0.19%. IWM also scored a 5Y total return CAGR of 3.44%.

Russell 2000 sector weightings %. Data source: Seeking Alpha

As seen above, the Russell 2000 is weighted toward four sectors: Technology, Industrials, Health Care, and Financials. However, it's important not to confuse IWM's tech sector weightings with a broad-based tech ETF like the Technology Select Sector SPDR ETF ( XLK ).

Accordingly, The Russell 2000 has a weighted average market cap of $2.85B (as of September 30). However, the XLK , a market-cap-weighted ETF, has a weighted average market cap of about $1.36T as of October 12. As such, I believe small-caps investing is a relatively higher-risk endeavor into less fundamentally sound companies that could be industry leaders in the future.

However, that thesis hasn't worked out over the past five years, as small-caps investing through IWM have underperformed the S&P 500 ( SPX ) ( SPY ) in total return terms.

While IWM outperformed SPY coming out of the COVID lows in March/April 2020, the price action of IWM/SPY reached a significant top in March 2021 as astute investors rotated out of small caps. The valuation surges in the fundamentally weaker small caps weren't expected to be sustained, as the pandemic boom and bust unveiled the underlying deficiencies of the small caps.

Moat classifications. Data source: Morningstar

According to Morningstar's data, nearly 91% of companies in SPY are either classified as having wide- or narrow-moat, ascertaining sustainable competitive advantages. In contrast, less than 4% of IWM's constituents are assessed to have similar moat ratings.

As such, it corroborates my view that IWM's significant underperformance is likely a reflection of the market's assessment of higher execution risks in an uncertain macroeconomic climate. Compounded by the risks of higher interest rates that benefited the larger companies with stronger balance sheets, I believe small-caps could continue to underperform.

Moreover, I believe the recent geopolitical risks emanating from the Israeli-Hamas conflict could keep investors away from the Russell 2000 in the near term. Why? I think it's still too early for us to ascertain the scale of the conflict. If it were to intensify and broaden, it could tip us into a hard landing , potentially hitting the small caps harder.

While IWM bulls could argue that the market could have priced in these headwinds, I urge caution.

IWM's price action has struggled for traction since it bottomed out in October 2022. As seen above, while buyers have defended significant pullbacks to the low $160s zones, they weren't keen to lift it beyond the $200 resistance level established in August 2022.

Furthermore, the steep collapse from IWM's July 2023 highs has nearly re-tested its March 2023 lows (regional banking crisis bottom). As such, I believe market operators have likely baked in the increasing risks of a recession or hard landing that could batter IWM harder than its large-cap peers. In other words, IWM could also bottom out at the current levels if macroeconomic conditions aren't as bad as investors anticipated.

Despite that, I expect the market to continue reflecting heightened risks on IWM in the near term. As such, without robust buying sentiments supporting a sustained reversal in IWM, the Russell 2000 could remain mired in a consolidation zone for some time, underperforming the S&P 500.

With that in mind, I believe a more cautious stance on the Russell 2000 should be embraced. Investors are urged to find opportunities in fundamentally stronger companies to drive outperformance.

Rating: Initiate Hold.

Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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