This month's market rotation into small caps is being led by a rebound in cheap stocks. A rally in small caps can sometimes be a sign of speculative fervor, but an analysis of the top-performing nonleveraged small-cap funds show that it is the value factor finding a bid. According to FactSet, three of the top five small-cap exchange-traded funds in July are explicitly focused on value, including the iShares US Small Cap Value Factor ETF (SVAL) .
That fund was up 11.4% for the month through Wednesday, compared to 7.4% for the broader iShares Russell 2000 ETF (IWM) .
Meanwhile, the other two funds in the top five — ProShares Russell 2000 Dividend Growers ETF (SMDV) and SPDR SSGA US Small Cap Low Volatility Index ETF (SMLV) — are cheaper than the broader small-cap sector across multiple valuation metrics, according to FactSet. Several factors could be contributing to the small-cap rally, including the rising confidence among traders of a Fed rate cut in September. Companies that are profitable, however, should be in better shape to navigate a period of rate cuts and a slowing economy, said Sean O'Hara, president of Pacer ETFs.
Investors can account for profitability by looking for stocks with lower price-to-earnings ratios, one of the metrics captured by many value funds. As of June 30, the broader IWM had a 14.4 P/E ratio, compared to about 11 for the value-tilted IWN, according to iShares.
"For those companies that are small cap ...
that are not profitable, I don't think e.