Small Cap ETFs’ Fuel Evaporates as Rates Rise

The small cap iShares Russell 2000 ETF (IWM) started 2023 looking strong, surging 14% in January. A rate hike put a dagger in the rally, and it’s been downhill from there. 

IWM tracks the leading market-cap-weighted index of U.S. small cap stocks, generally for companies with market caps of $250 million to $2 billion. Small cap investors typically look for up-and-coming companies that can experience fast growth.  

The prospects for equities including small caps have clouded. While the leading indexes have gained so far this year, they are coming off an ugly 2022. Rising interest rates have caused capital to flow from stocks to bonds.  

The SPDR S&P 500 ETF Trust (SPY), which represents the most diversified U.S. stock market index, dropped 19% last year. The tech-heavy Nasdaq composite did worse: The Invesco QQQ Trust (QQQ), which tracks the Nasdaq composite fell 33%.  

Last year, IWM dropped 22%. Through a little over two months in 2023, the stock market indexes have gained back a little ground.  

SPY, QQQ, IWM: Mixed Recoveries 

As of March 16, here are the leading stock market index ETFs’ year-to-date performances: 

• At about $395, SPY has added less than 1%.  
• At around $305, QQQ has jumped 12%. 
• At $177, IWM has added 1.2%.  

IWM has done slightly better than the diversified S&P 500 but worse than the tech-heavy Nasdaq.  

Meanwhile, the recent fund flows in related ETFs are a warning sign for the three indexes. 

Fund Flows Issue a Warning 

Since the start of 2023 through March 9, the ETF.com Fund Flows tool indicates that the ETFs tracking the three leading stock market indexes have seen significant redemptions: 

The above chart highlights the flow of capital into fixed income ETFs and out of equity ETFs. SPY led the way with over $12 billion in outflows, IWM experienced $2.24 billion, and QQQ lost $2.99 billion. As of March 9, 

• At $385.91, SPY had $366.65 billion in assets under management. At that level, the outflow amounts to around 3.27%.  
• At $288.55, QQQ had $154.6 billion in assets, and the outflow reflected approximately 1.9%.  
• At $176.18, IWM had $52.4 billion in assets. The outflow represents around 4.3%.  

IWM and small-cap-related ETFs have experienced the most significant outflows on a percentage basis, an omen for small cap stocks.  

Rising Rates Ding Small Caps 

After years of low rates, the short-term fed funds rate soared to 4.5%-4.75% from zero at the beginning of last year. The latest inflation data and Fed Chairman Powell’s comments and testimony on Capitol Hill this month point to a continuation of rate hikes.  

Short-term rates are heading for levels above 5%, and hikes to over the 6% level are not out of the question if inflationary pressures continue. Moreover, the central bank’s quantitative tightening program reducing the Fed’s balance sheet by $95 billion monthly puts upward pressure on interest rates further along the yield curve.  

Rising rates are why capital flows from stocks to bonds, and fixed income ETFs are seeing inflows and the leading stock market ETFs seeing outflows.  

Meanwhile, small cap companies need fuel for growth, which is funding. The current interest rate environment challenges emerging companies as it increases debt servicing costs.  

Moreover, as the credit environment tightens, financing can become elusive. Management at small cap companies is scrambling for credit to fund projects and, in many cases, abandoning dreams or reducing expenditures that create growth to survive. Cash-rich large cap companies give far more staying power in the current environment than the cash-starved small caps.  

Meanwhile, as credit tightens, the odds of a recession increase. An overall economic contraction is terrible news for the small cap companies and IWM. 

After recovering to a high in early February, IWM ran out of upside steam and made lower highs and lows. The bearish price trend and significant outflows are warning signs that small cap stocks will suffer the most from rising interest rates and the increasing odds of a recession over the coming months.  

Last week, the failure of Silvergate Capital and Silicon Valley Bank was terrible news for small cap stocks and the overall market, as many startup tech companies that are small caps depended on Silicon Valley Bank for funding. The outflow of deposits forced both to sell assets at a loss.  

Banks invest in U.S. government debt securities that are safe assets if held to maturity. However, rising interest rates have caused them to lose mark-to-market value, and sales before maturity result in losses.

The bottom line is the failure of two financial institutions threatens other banks. SVB’s failure is the second biggest behind Washington Mutual, as SVB had over $200 billion in assets. Regulatory oversight and stress tests did not prevent the losses.  

The redemptions that preceded SVB’s failure were a warning sign. Rising rates have unintended consequences, and systemic risks could weigh on stocks and small caps could face the greatest challenge.