Small-Cap ETFs: Navigating a Roller Coaster of Momentum

The start of 2025 has proven tumultuous for small-cap stocks, epitomized by the iShares Russell 2000 ETF (IWM). This investment vehicle, which tracks 2,000 small and midsized companies within the larger Russell 3000 index, experienced a sharp decline of 3.4% last week, underscored by the release of stronger-than-expected jobs data. The report ignited concerns about rising Treasury yields and the potential delay of Federal Reserve interest rate cuts, prompting a swift exit from small-cap investments. According to MarketWatch, investors withdrew over $871 million from the IWM during the week ending Tuesday, making it one of the three ETFs with the largest net outflows, as per FactSet data.

Despite the rapid selloff, investor sentiment shifted quickly. A relatively tame consumer-price index report on Wednesday spurred a relief rally, leading to IWM’s largest single-day percentage gain since November 6, driving gains of over 3.5% for the week. As it began to recover, hopes arose that these small-cap equities could reclaim momentum.

The Sensitivity of Small Caps to Interest Rates

According to Philip Greenblatt, portfolio manager at Easterly Investment Partners, small-cap indices exhibit heightened sensitivity to shifts in interest rates. “When you have a large portion of the small-cap index that is super sensitive to interest rates…their outlook is highly dependent on a lower discount rate that gets applied to their future cash flows,” Greenblatt noted. Given many of these companies sport negative earnings and significant debt, any hint of reduced interest rates can lead to a price surge, drawing investors back in.

The composition of the Russell 2000 signals where its volatility stems from. Financials and biotechnology sectors together constitute about 25% and 14% of the index, respectively. In theory, lower interest rates favor regional banks—allowing them to pay less to depositors while boosting demand for loans. Biotech firms, with their inherent reliance on successful clinical trials and breakthroughs, demonstrate the platform’s potential for volatility driven by significant market events.

Market Perceptions: A Short-term Trade

Greenblatt posits that such erratic responses to market conditions indicate many investors view small caps as a “one-day trade.” He argues that the best case for small-cap equities lies in a broader examination of corporate earnings rather than a fixation on the Federal Reserve’s actions. “The market needs to break free from its reliance on the Fed,” he added, suggesting that small-cap stocks are ripe for active management combined with a value-oriented strategy that can reveal stable firms with strong balance sheets and real free cash flows.

Looking Ahead: A Change in Administration and Investment Landscape

The recent U.S. presidential election brings palpable changes to policy expectations. Investors are betting that Donald Trump’s return to office could create a favorable environment for small caps through tax relief, reduced financial regulations, and adjustments to trade tariffs. Following the election, small-cap stocks surged, lifting the IWM to near-record highs by November. However, this momentum proved short-lived, with the ETF returning to pre-election levels by mid-January, according to FactSet data.

Portfolio manager Gregory Spiegel from Neuberger Berman expressed measured optimism regarding small-cap volatility, emphasizing that the incoming administration’s pro-business stance signifies a reindustrialization of America, which he believes will benefit smaller companies. The anticipated reshoring renaissance promises to bring supply chains back to the U.S., favoring smaller firms that primarily generate domestic revenue compared to larger corporations with extensive international exposure.

Spiegel believes that this policy agenda will afford small-cap companies greater discretion in capital allocation and drive expansion in manufacturing capabilities, ultimately bolstering earnings and cash flows.

Performance Snapshot: Top and Bottom-Performing ETFs

As always, ETFS offer a snapshot of prevailing market sentiments. According to FactSet data, the following were the top performers over the past week through Wednesday:

Meanwhile, here are the bottom performers:

As market dynamics continue to evolve alongside policy shifts and economic indicators, the small-cap segment remains an engaging focal point for investors with both an appetite for risk and a keen interest in identifying potential growth opportunities.