Small Cap ETFs Surge As House Passes Tax Bill

House Republicans approved the biggest U.S. tax overhaul in three decades with some tweaks with the aim of making America more competitive. The plan will slash the corporate income tax rates from 35% to 20% as proposed but reduce the number of individual income tax brackets from seven to four instead of three. The bill would limit state, local and mortgage interest deduction, eliminate personal exemption, and nearly double the standard deduction.

The tax reform plan was passed with 227 votes in favor and 205 against. The step marks a significant achievement for the Trump administration and his promise to deliver historic tax cuts for Americans by the end of the year. Additionally, tax reform is the most prestigious legislative move for Republicans to enter into 2018 midterm elections (read: Winners & Loser of Trump's Tax Reform).

This has led to a huge rally in the broad stock market with small caps leading the way higher. The Russell 2000 index climbed 1.6% on Nov 17, leading to year-to-date returns of 9.6%. This is especially true as small caps are the biggest beneficiaries of the tax cuts relative to big companies. Companies on the Russell 2000 pay a median effective tax rate of 31.9% while the larger, multi-national companies on the S&P 500 pay a median effective tax rate of 28%, according to Thomson Reuters data. The median tax rate for the 30 mega-cap stocks on the Dow Jones Industrial Average is even low at 23.8%.

ETF Impact

The surge also sent the small-cap ETF space into the green territory on Nov 17. In particular, PowerShares DWA SmallCap Momentum Portfolio DWAS, Guggenheim S&P SmallCap 600 Pure Value ETF RZV and WisdomTree US SmallCap Dividend ETF (MNE:DES) stole the show. These funds gained nearly 2% on the day (see: all the Small Cap ETFs here).

Below we profile these ETFs in detail and discuss some of the specifics behind their recent rally.

DWAS

This ETF offers exposure to the small-cap segment of the broad U.S. stock market. It follows the popular Dorsey, Wright & Associates proprietary selection methodology that is designed to identify small-cap firms with positive relative strength characteristics in an attempt to follow companies with strong forward momentum. The product holds a basket of 200 stocks with none holding more than 1.93% of assets. From a sector look, healthcare takes the top spot with 25.8% share while financials, industrials, and information technology, round off the next three spots. The fund has $219.9 million in AUM and charges investors 60 bps a year in fees (read: Small Cap ETF Hits New 52-Week High).

RZV

This fund provides exposure to the pure value segment of the small-cap market by tracking the S&P SmallCap 600 Pure Value Index. It holds a well-diversified portfolio of 156 stocks with each security holding less than 2% of assets. In terms of sector exposure, consumer discretionary takes the largest share at 29.2% while industrials, financials and information technology round off the next three spots. It has been able to manage $178.4 million in its asset and charges 35 bps in fees per year from investors. RZV has a Zacks ETF Rank #3 (Hold) with a High risk outlook (read: Small Cap ETFs & Stocks Crushing Russell 2000).

DES

This ETF offers exposure to the dividend-paying small-cap companies in the U.S. equity market by tracking the WisdomTree U.S. SmallCap Dividend Index. Holding 655 stocks in its basket, it is widely spread out across components with each security holding less than 2% share. Consumer discretionary, industrials, real estate and financials are the top four sectors accounting for a double-digit exposure each. The product has amassed nearly $2 billion in its asset base and charges 38 bps in annual fees. It has a Zacks ETF Rank #3 with a Medium risk outlook.

What Lies Ahead?

Though the tax bill was passed by the House, it needs to get through Senate, which passed the $1.4 trillion budget resolution last month, paving the way for the approval of the tax bill. Given that the tax reform will come into play by the end of the year or early next year, small caps will continue to enjoy the rally. Additionally, increasing activities in the economy will fuel growth in these pint-sized stocks.

This is because growth in the U.S. economy has been accelerating with GDP expanding 3% year over year in the third quarter, following 3.1% growth in the second quarter. This represents the best back-to-back quarters of at least 3% growth since 2014. Unemployment dropped to the lowest level since December 2000 to 4.1%.

Americans also have an optimistic view of the economy with confidence hitting the highest level in almost 17 years. The Conference Board consumer confidence index jumped to 125.9 in October from a revised 120.6 in September. Meanwhile, consumer spending, which accounts for more than two-thirds of U.S. economic activity, recorded its biggest increase in more than eight years in September.

Against such a backdrop, small-cap stocks led the way higher as these are closely tied to the U.S. economy and do not have much exposure to the international market. These pint-sized stocks generate most of their revenues from the domestic market and generally outperform on improving American economic health (read: 5 Biggest ETF Winners of Trump Trade Resurgence).

Moreover, after hiking rates in December 2015 and December 2016, the Fed has raised interest rates two times this year and is on track for another liftoff in December. This indicates a stronger economy and propels small-cap stocks higher.

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WISTR-US SC DV (DES): ETF Research Reports

GUGG-SP 600 PV (RZV): ETF Research Reports

PWRSH-DWA SC MO (DWAS): ETF Research Reports

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