BlackRock's IWM ETF Waving a Yellow Flag for Advisors

Decline in small-cap ETF has preceded drops in SPY in recent years.

Reviewed by: Staff
Edited by: Ron Day

As financial advisors know, the U.S. stock market often operates as one big, coordinated machine. 

Prices of companies of different sizes and factors move in unison, up or down. As the expression goes, it's a "stock market, not a market of stocks."

But as has been the case prior to several significant declines in the $503 billion SPDR S&P 500 ETF Trust (SPY) in recent years, the small cap segment of the market, as represented by the$62 billion iShares Russell 200 ETF (IWM), lags badly behind SPY for a few months, and soon afterward, SPY weakens along with it. So, with IWM underperforming SPY by 6.5% over the three months through Monday's close, it is worth paying attention to.

Since mid-December, SPY has gained 9.0% versus only 2.5% for IWM. This could be brushed off as just a temporary glitch in the small cap market, which does not have the benefit of big guns like the Magnificent Seven stocks. 

However, it's not unlike a pattern that preceded several 10% corrections or worse in SPY over the past several years. IWM has been the warning flag in the past, so respecting its current weakness is something investment advisors best not ignore.

I looked back at each drop of 10% or more since 2018, a year in which few likely remember there were two of them, early in the year and during the fourth quarter. Then there was 2020’s pandemic debacle during the first quarter, 2022’s generally rough year for SPY and a soon-forgotten 10% dip before the Halloween market bottom in 2023. In nearly all these cases, and others that produced drops of 5% or more, but not as much as 10%, there was a suspicious character on the scene.

IWM May Be Forecasting SPY Weakness 

That character was IWM, which lagged SPY by 5% and often more, before SPY joined it to the downside. So, when I see the two market benchmarks go in opposite directions as they have done recently (even the past two weeks, SPY is up 1%, IWM down 1.8%), it doesn’t scream, but it does get my attention. Because for all the economic early warning signals touted by investing pros, sometimes the market just tries to tell us something. And we should listen, even if it doesn’t change the nature of how money is invested. 

For those who see something to this intriguing price action, but are small cap afficionados, there are plenty of other places to look. Those include the $76 billion iShares Core S&P Small Cap ETF (IJR), which is based on the S&P Smallcap 600 index, the chief rival of the Russell 2000 which IWM tracks. The latter index is broadly considered to be of questionable quality, as it currently contains many companies that are essentially living on debt. With so much corporate debt starting to reach a “cliff” soon, that could prompt some to seek higher-quality small cap ETFs. IJR represents one common alternative for financial advisors. 

Don’t Have a Cow, Man…But Maybe a Calf? 

As that popular quote from TV’s Bart Simpson suggests, another increasingly popular small cap alternative is the $9 billion Pacer US Small Cap Cash Cows 100 ETF (CALF). This fund prioritizes free cash flow yield versus highly indebted businesses. It sells at 11x trailing 12-month earnings, and its 101% turnover rate implies that it is proactive in replacing businesses whose fortunes decline. This is one of many examples’ advisors can find across the ETF landscape where they are still researching an index-based product, but where something beyond company size (market capitalization) factors into what they own for their clients.

This could all be just a false signal. The post-pandemic era is filled with them. But as experienced advisors know, it is better to respect and understand risk than simply ignore it. 

Rob Isbitts was an investment advisor for 27 years before selling his practice to focus on ETF research and education. He is based in Weston, Florida. Contact him at  [email protected] and follow him on LinkedIn.