Despite the fact that Janet Yellen made a recent reference to coming rate hikes by the Federal Reserve, small-cap stocks have substantially outperformed their large-cap peers so far in 2016. Small-cap funds are up on average over 11% so far for the year, compared to a gain of only 4% for large-cap funds and 7.67% for the Standard & Poor’s 500 Index with dividends reinvested. While there are definitely some reasons why small-cap stocks may suffer if rates rise, they may also turn out to be winning performers in this environment.

Possible Downside

Small-cap stocks may get hit with higher borrowing costs when rates rise, which could make it more difficult for them to operate. The loans for small companies tend to be adjustable-rate loans, so this cost would rise directly with any increase in interest rates. And a hike in rates may also make small-cap stocks inherently less attractive to investors, as few of them pay any dividends, which makes them similar to bonds that have no maturity. But small cap-stocks have shaken off these factors to post strong returns for the year, and they may keep going even when rates do start to rise. (For more, see: Valuing Small-Cap Stocks.)

Sam Stovall, U.S. equity strategist for S&P Global Market Intelligence, told Investment News that they were less affected by Yellen’s statement than their large-cap cousins, which may also become less attractive to investors after a couple of rate hikes. In a note to his clients, Stovall wrote, “Maybe the 'great rotation' pertains less to stocks versus bonds than it does between large- and small-cap equities.”

A rate increase would also strengthen the price of the U.S. dollar, which would in turn raise the price of exports to other countries. This would most likely have a larger effect on large-cap companies that have extensive overseas markets and holdings, whereas the small-cap sector is much more domestic. Stovall also noted the lower correlation of small caps to the dollar than large caps in his client communication. “In the past 36 months, the S&P 500 has recorded a 0.72 monthly correlation with the U.S. Dollar Index versus a correlation of 0.55 for the S&P SmallCap 600.” Stovall also said that small caps currently have greater projected growth than large-cap stocks. (For more, see: Small-Cap Research Can Have a Big Impact.)

Small-Cap Funds

Investors who want to get in on the growth in the small-cap sector can consider exchange-traded funds (ETFs) such as the iShares Russell 2000 Value (IWN), which is up 14.10% for this year, or the Vanguard S&P Small-Cap 600 Value ETF (VIOV), which is up 15.57% in 2016. (For more, see: The Top 3 Small Cap ETFs for 2016.)

On the actively-managed side, small-cap value funds have been leading the way. Aegis Value (AVALX) is up a whopping 58% for the year, and nearly half of its holdings are in stocks of basic materials companies such as Coeur Mining (CDE), a silver mining firm whose stock has risen by 452% this year. Alliance One International (AOI) is its largest holding, and it is up 80% for the year. Hodges Pure Contrarian fund (HDPCX) has been another good pick. The small-cap growth sector’s performance has been much more muted, with the average fund posting growth of 6.16%.

The Bottom Line

Time will tell whether small-cap stocks are able to continue their strong performance when interest rates start to rise. Although they may be in a vulnerable position in some ways, they may fare better than their large-cap cousins because of their domestic focus. (For related reading, see: Does Investing in Small-Cap Stocks Have Advantages over Investing in Big-Cap Stocks?)

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