U.S. small caps are confounding investors on multiple fronts this year. The laggard status of major small-cap benchmarks, such as the Russell 2000 Index and the S&P SmallCap 600 Index, comes after smaller stocks surged in the later stages of 2016.
With new President Donald Trump's anticipated focus on the domestic economy, small caps were expected to continue rallying in 2017. Additionally, the Federal Reserve's plans to boost interest rates were expected to aid smaller stocks. Higher interest rates usually mean a stronger dollar, which can help small caps because many of these companies generate the bulk of their sales in the U.S. (See also: An Introduction to Small-Cap Stocks.)
Although small caps are disappointing to start 2017, investors can still be on the less risky side of this equation with dividends. The ProShares Russell 2000 Dividend Growers ETF (SMDV) is an idea to consider. While small caps are usually prized for growth over income, many of the companies held by this fund have boosted dividends in recent years.
SMDV captures this theme by holding only those members of the Russell 2000 that have dividend increase streaks of at least 10 consecutive years. While SMDV is participating in the broader small-cap exchange-traded fund (ETF) lethargy seen this year, historical data suggest that small-cap dividend growers usually perform well in the months following an interest rate increase, something the Fed delivered in March. (See also: Why Small Caps and Dividends Go Together.)
"Small-cap dividend growth stocks produced positive returns in the six-month and one-year periods following two of the most recent three periods in which the Fed has hiked rates," according to ProShares. "In fact, small-cap dividend growth stocks outperformed small- and large-cap stocks in general over the same periods. Companies that continually grow their dividends can be a sign of higher quality, having stronger balance sheets with less leverage, and being guided by shareholder-friendly management teams."
With its focus on dividends, SMDV predictably looks a lot different at the sector level than the traditional Russell 2000. For example, the ProShares ETF allocates over 28 percent of its weight to utilities stocks, by far its largest sector allocation. Conversely, the Russell 2000 devotes just 3.7 percent to utilities companies. Technology and healthcare stocks combine for about 31 percent of the Russell 2000, but those sectors are just the second and third smallest groups in SMDV, combining for about 9 percent of the ETF's roster. (See also: 5 Dividend Growth ETFs to Consider.)
Another result of SMDV's dividend focus is a much smaller lineup than a traditional Russell 2000 ETF. SMDV holds just 58 stocks, while the largest Russell 2000-tracking ETF holds almost 1,960 small caps. It is hard to argue with SMDV's results. Since the ETF debuted just over two years ago, it has returned 32.4 percent, or about two and a half times the returns of the Russell 2000 over the same period. (See also: Playing Small Caps in This Market? The Key Is Dividends.)