Small-cap stocks and the relevant exchange-traded funds (ETFs) are notable laggards to start 2017. Given the volatile nature of smaller stocks and the need of many smaller companies to raise money via capital markets, some investors may be apt to blame the struggles of small-cap ETFs on the Federal Reserve's plans to raise interest rates.

The Fed did just that last week, but historical data suggest that major small-cap benchmarks, such as the Russell 2000 Index, do not always wilt when rates rise. The Russell 2000 is one of the most widely followed small-caps benchmarks and is accessible via the iShares Russell 2000 ETF (IWM), among other ETFs. Home to $37.4 billion in assets under management, IWM is the largest small-cap ETF trading in the U.S. (See also: IWM: iShares Russell 2000 Index ETF.)

More importantly, IWM and its underlying index can actually deliver upside when U.S. borrowing costs inch higher. "Index returns in each of the last four cycles have been negative after one month, but in the three most recent cycles, index returns were up by double digits after one year. The 2015 cycle had the largest trough-to-peak swing, down -12.3% after one month, but up 22% after twelve months – a remarkable 34.3 percentage point turnaround," said FTSE Russell of the Russell 2000's performance during Fed tightening cycles dating back to 1994. 

There are reasons why small caps can prove durable in rising rate environments. Smaller companies usually derive most of their revenue on a domestic basis, meaning they are not as inversely correlated to a rising dollar as are multinational large-cap firms. Second, Fed rate hikes can be seen as votes of confidence in the U.S. economy, benefiting cyclical assets such as small caps. (See also: Why Small Caps May Be a Good Bet if Interest Rates Rise.)

"Rising interest rates don't necessarily lead to a decrease in small cap performance, as reflected by the Russell 2000 Index," said FTSE Russell. "But it's nonetheless important to note that volatility may change direction, which may warrant caution. This period is the only one of the four rate cycles observed where the Fed waited a full year between its first and second rate increases. The Fed may not be so quiet in 2017, and any activity is likely to have an effect on small caps."

Indeed, IWM fits the bill as cyclical. The ETF's top three sector allocations, which combine for 51% of its weight, are financial services, technology and industrials. Those are all considered cyclical sectors. (See also: IWM: An ETF Performance Case Study.)

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