Among the three primary market capitalization segments, if there’s one that’s been highly tethered to Federal Reserve policy, it’s small-caps. Smaller stocks and related ETFs were drubbed when the central bank commenced its rate tightening cycle in 2022. More recently, its higher-for-longer policy has acted as a headwind to a small-cap rebound. That’s dampened investors’ enthusiasm for the asset class despite historically depressed valuations.
Arguably, the environment has become so challenging (and disappointing) for small-caps that many investors may be ignoring this corner of the market. But that could also imply the time is right to consider ETFs such as the WisdomTree US Smallcap Quality Dividend Growth Fund (DGRS). Year to date, the fund is beating the S&P SmallCap 600 Index. Over the past three years, it generated positive returns while the Russell 2000 and S&P SmallCap 600 traded lower.
Noteworthy Showing Over Past Several Years
Understanding why small-caps have scuffled against the backdrop of higher interest rates and the Fed disappointing when it comes to lowering rates is easy. Many smaller companies had flimsy balance sheets, debt burdens, a need for capital, or all three prior to rates rising. Thus higher interest rates plagued the group.
However, those traits aren’t applicable to many DGRS holdings. That largely explains why the ETF has outperformed the aforementioned small-cap indexes even without assistance from the Fed. Past performance isn’t a promise of future returns. But DGRS’ showing over the past several years is noteworthy.
“Even the S&P SmallCap 600 index, which is a higher quality subset of the U.S. small-cap market compared to the Russell 2000, is now burdened with the highest interest costs on debt in a decade. This is unique to smaller companies as the increase in interest costs diminishes further up the size spectrum,” noted Brian Manby, WisdomTree associate for investment strategy.
Additional DGRS Advantages
DGRS, which turns 11 years old next month, has some other advantages. The $360.55 million ETF allocates less than 9% of its roster to healthcare and tech stocks. Those corners of the small-cap universe are historically plagued by high interest rates. Yet the ETF’s factor mix is compelling regardless of whether the Fed pares rates.
“The performance and volatility tandem trails the low volatility factor, but the past few years suggest this may be changing. Low volatility has been the worst performing factor among small caps in the post-pandemic environment, while quality has led with relatively uninterrupted upside. Since March 2020, quality has delivered the best risk-adjusted returns among small-cap factor pairs,” concluded Manby.
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