U.S. small-cap stocks have been disappointments this year relative to large caps and international small caps, but investors may want to consider revisiting U.S.-focused small-cap exchange-traded funds (ETFs) against the backdrop of higher interest rates. The O'Shares FTSE Russell US Small Cap Quality Dividend ETF (OUSM) is an option for conservative investors looking to stick with small caps even as the Federal Reserve continues its efforts to normalize U.S. monetary policy. Earlier this month, the Fed boosted borrowing costs for the second time this year, and it is widely expected that one more rate hike will be unveiled this year followed by another three in 2018.

OUSM, which tracks the FTSE Russell US Qual / Vol / Yield Factor 3% Capped Index, is not an old ETF. The fund debuted in December 2016, but that also means it has been around for each of the Fed's three most recent rate hikes. In other words, OUSM only knows life in a world of higher U.S. interest rates. To its credit, OUSM has mustered a gain of more than 3% year to date, and historical data suggest that this and other small-cap ETFs could be poised for more upside as rates keep climbing. (See also: The Impact of a Fed Interst Rate Hike.)

"There are several possible reasons to explain why small caps outperform large caps in this environment," according to O'Shares research. "Rising rates tend to coincide with economic expansion, which would benefit smaller companies. Another reason is, foreign sales by small-cap companies tend to make up a smaller percentage of total sales compared to large-cap companies. This makes them less sensitive to increases in the U.S. dollar, which may strengthen as interest rates increase."

Small caps, both U.S. and international fare, are typically more levered to the local economies in which they are based. In the case of smaller U.S. companies, their exposure to the domestic economy makes them beneficiaries of a stronger dollar, whereas large, multi-national companies that generate significant revenue in ex-U.S. markets can be pinched by a strengthening greenback. (See also: Why Small Caps May Be a Good Bet if Rates Rise.)

Real estate is OUSM's largest sector allocation at 19%, but the ETF is heavily cyclical, as highlighted by a combined 43% weight to the consumer discretionary, industrial and financial services sectors. Cyclical sectors historically perform well when interest rates rise. "Small-cap stocks outperformed large-cap stocks in three of the past four Fed tightening events and are outperforming in the current cycle," according to O'Shares research. (See also: Finding Outperforming Small-Cap ETFs.)

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