Here's why small-cap ASX ETFs are on the rise

Some are outperforming the exchange-traded funds tracking the ASX 200 and ASX 300.

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ASX exchange-traded funds (ETFs) invested in small-cap companies listed in Australia or overseas are lifting in value as central banks worldwide begin cutting interest rates.

Small-cap companies tend to do better when rates are lower because this reduces the cost of the debt they need to carry to keep on investing in their growth and development.

ETF issuer Vanguard says small-cap options are already more popular with US investors following the Federal Reserve's two interest rate cuts this year.

There was the bigger-than-expected first rate cut of 50 basis points in September, followed by a second rate cut of 25 basis points this month.

In the latest quarterly Vanguard ETF Industry Perspectives newsletter, equity index senior investment product manager, Andrey Kotlyarenko said money flows into small-cap US ETFs have been increasing.

Historically, he said this was a pattern that usually coincided with interest rate cuts.

Kotlyarenko commented:

The Fed's 50-basis-point rate cut—its first cut since before the Fed began raising rates in response to the inflationary spike driven by the COVID-19 pandemic—created a fresh opportunity to look closely at small-cap equities, which historically have outperformed the broader market after rate cuts.

The lower cost of capital that has followed rate cuts has correlated with investors showing greater interest in smaller companies, whose growth prospects can be hampered when borrowing costs are high.

With further rate cuts expected in many countries next year, including Australia, Kotlyarenko said investors appeared more bullish on small-cap stocks now.

Kotlyarenko said Q3 inflows into small-cap ETFs in the US had leapt to $16.5 billion. This was higher than the inflows over the previous six months, which only totalled $9.4 billion.

The trend of small-cap ETFs performing better when rates are lower or falling is universal across the most recent historical rate-cutting cycles, Kotlyarenko said.

He commented:

During other rate-cutting cycles—such as the dot-com bubble, the global financial crisis, and the post-COVID pandemic recovery—interest in small-caps spiked.

In the 12 months following those initial rate cuts, returns of the four main US small-cap indexes performed strongly.

More to the point, each of these indexes outperformed the broad equity market during those past rate-cutting cycles.

But crucially, each small-cap index isn't built quite the same as another, so their performances can diverge.

For example, during the first year of COVID-19, when central banks worldwide slashed interest rates, the four main US small-cap indexes soared.

However, there was a 6.66% disparity in performance between the No. 1 performing index, the Russell 2000, and the No. 4 performing index, the CRSP US Small Cap Index.

Let's examine some of the ASX ETFs available to Aussie investors that track small-cap stocks either here or overseas, and review how they are performing in the year-to-date (YTD) and over the past 12 months.

How are small-cap ASX ETFs performing?

In 2024, we have indeed seen an increase in the unit price of several ASX small-cap ETFs.

Not only that, but some of them are outperforming ASX ETFs that track the ASX 200 or ASX 300, which incorporate large-caps like Commonwealth Bank of Australia (ASX: CBA) and BHP Group Ltd (ASX: BHP).

Below are four examples of ASX ETFs tracking small-cap shares. Take note of their year-to-date and 12-month growth rates compared to those of two peers that track the ASX 200 and ASX 300.

The iShares Core S&P/ASX 200 ETF (ASX: IOZ) tracks the S&P/ASX 200 Index (ASX: XJO). On Tuesday, it is trading for $33.84 per unit, up 9.7% YTD and 19.84% over 12 months.

The Vanguard Australian Shares Index ETF (ASX: VAS) tracks the S&P/ASX 300 Index (ASX: XKO). Today, it is trading for $104.26 per unit, up 10.69% YTD and 20.12% over 12 months.

ASX ETFs tracking Aussie small-cap shares

iShares S&P/ASX Small Ordinaries ETF (ASX: ISO)

The iShares S&P/ASX Small Ordinaries ETF is trading at $4.85 per unit. It's up 6.59% in 2024 and up 17.15% over the past 12 months.

The ISO ETF aims to track the performance of the S&P/ASX Small Ordinaries Accumulation Index, before fees.

The index measures the performance of small-cap ASX shares in the ASX 300, excluding the S&P/ASX 100 Index (ASX: XTO).

The ETF's top three underlying holdings are Life 360 Ltd (ASX 360), Alcoa Corporation CDI (ASX: AAI), and Zip Co Ltd (ASX: ZIP). The management fee is 0.55%.

Vanguard MSCI Australian Small Companies Index ETF (ASX: VSO)

The Vanguard MSCI Australian Small Companies Index ETF is trading at $69.76 per unit. It's up 9.86% in 2024 and up 18.44% over the past 12 months.

The VSO ETF aims to track the performance of the MSCI Australian Shares Small Cap Index before fees. The index includes stocks that pass certain liquidity and market capitalisation criteria.

Its top three holdings are Evolution Mining Ltd (ASX: EVN), NextDC Ltd (ASX: NXT), and JB Hi-Fi Ltd (ASX: JBH). The management fee is 0.3%.

ASX ETFs tracking US or international small-cap shares

iShares S&P Small-Cap ETF (ASX: IJR)

The iShares S&P Small-Cap ETF is trading at $196 per unit. It's up 22.68% in 2024 and up 33.79% over the past 12 months.

The IJR ETF aims to track the performance of the S&P Small-Cap 600, before fees.

The index measures the performance of the small-cap segment of the US stock market. It is comprised of 600 companies with a market capitalisation of between US$1 billion and US$6.7 billion.

The ETF's top three equity holdings are Mueller Industries Inc (NYSE: MLI), Carpenter Technology Corporation (NYSE: CRS), and Comerica Inc (NYSE: CMA). The management fee is 0.07%.

Vanguard MSCI International Small Companies Index ETF (ASX: VISM)

The Vanguard MSCI International Small Companies Index ETF is trading at $70.31 per unit. It's up 17.84% in 2024 and up 25.06% over the past 12 months.

The VISM ETF seeks to track the returns of the MSCI World ex-Australia Small Cap Index (with net dividends reinvested) in Australian dollars before fees.

The index tracks the performance of small-cap companies in 22 developed countries (excluding Australia). They include the United States, Canada, Japan, and Europe.

Its top three holdings are Carvana Co (NYSE: CVNA), Interactive Brokers Group, Inc. (NASDAQ: IBKR), and Nutanix Inc (NASDAQ: NTNX). The management fee is 0.32%.

Motley Fool contributor Bronwyn Allen has positions in Alcoa, BHP Group, and Zip Co. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Interactive Brokers Group and Zip Co. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has recommended Nutanix. The Motley Fool Australia has recommended Jb Hi-Fi. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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