There Was a Wild Ride for Small-Cap ETFs. Can They Regain Momentum After Trump Takes Office?

The start of 2025 has been challenging for small-cap stocks, which have faced considerable volatility and investor uncertainty.

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The iShares Russell 2000 ETF (IWM), a benchmark fund tracking 2,000 small and midsized companies within the Russell 3000 Index, fell 3.4% last week. This decline followed stronger-than-expected jobs data, which spurred a surge in Treasury yields. The spike rattled equities and led investors to reassess the timeline for Federal Reserve interest rate cuts, with expectations shifting toward a delay until later this year.

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The selloff triggered significant outflows from the small-cap ETF, with investors withdrawing over $871 million during the week ending Tuesday. According to FactSet data, this made IWM one of the top three ETFs with the largest net outflows among more than 1,000 tracked funds.

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Despite the initial downturn, a midweek rally offered relief. A relatively mild Consumer Price Index (CPI) report on Wednesday sparked gains in both stocks and bonds. IWM experienced its largest daily percentage increase since November 6, climbing over 3.5% for the week and nearly erasing earlier losses. According to FactSet, the ETF is now on track for its strongest week since late November.

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Philip Greenblatt, portfolio manager at Easterly Investment Partners, explained the dynamics driving small-cap stocks. “A large portion of the small-cap index is highly sensitive to interest rates. Many of these companies have negative earnings and significant debt, making their outlook heavily reliant on lower discount rates applied to future cash flows. When there’s even a hint of rate cuts, these stocks rally sharply as investors rush in,” Greenblatt said.

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Small-cap stocks are significantly influenced by the performance of financials and biotechnology firms, which collectively account for around 39% of the Russell 2000 Index, according to FactSet data.

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For regional banks, lower interest rates can boost profitability by reducing the cost of deposits and encouraging loan demand. Meanwhile, biotechnology firms, known for their volatility, often experience dramatic price movements driven by clinical trial outcomes or breakthroughs in drug development. These characteristics underscore why small-cap stocks are so reactive to macroeconomic signals, including rate changes.

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Greenblatt noted that small-cap stocks are often treated as speculative short-term trades rather than long-term investments. “The best case for small caps is a focus on corporate earnings rather than an overreliance on the Federal Reserve’s actions. The market needs to break free from its dependence on the Fed,” he said.

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He emphasized the importance of active management and value-oriented strategies in this segment. By identifying companies with solid balance sheets and real free cash flows, investors can uncover long-term opportunities rather than engaging in speculative betting.

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The 2024 U.S. presidential election has introduced new policy dynamics, with Donald Trump’s return to the White House generating optimism for small-cap stocks. Investors anticipate that Trump’s policy agenda—centered on tax relief, reduced financial regulations, and increased tariffs—could reshape the investment landscape for smaller companies.

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This optimism initially fueled a post-election rally in small-cap stocks, pushing IWM to near-record highs in November. However, the rally lost momentum, and the ETF has since returned to its pre-election levels, according to FactSet data.

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Gregory Spiegel, portfolio manager for Neuberger Berman’s small-cap team, is not overly concerned about recent volatility. “The markets are too focused on the pace of interest-rate cuts, missing the bigger picture of America’s reindustrialization under the new administration,” he said. He highlighted Trump’s pro-growth, pro-business policies as catalysts for long-term economic transformation.

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A key theme expected to benefit small-cap stocks is the reshoring of supply chains and the return of manufacturing jobs to the U.S. Smaller companies, which derive the majority of their revenue domestically, stand to gain disproportionately compared to megacap firms with significant international exposure.

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Spiegel believes this shift will allow smaller companies to make more strategic capital allocation decisions. By expanding manufacturing capacity and investing locally, these firms could see improved earnings and cash flows under the Trump administration’s policy framework.

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Small-cap stocks remain a high-risk, high-reward segment, influenced heavily by macroeconomic data and policy developments. While short-term volatility persists, the potential for long-term gains exists, particularly for investors willing to adopt a value-driven approach and focus on domestic growth opportunities.

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In the current environment, investors may benefit from identifying small-cap companies with strong fundamentals and stable cash flows while also keeping an eye on broader policy shifts that could reshape the economic landscape.

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As small caps navigate a turbulent start to the year, they remain a sector of interest for those seeking exposure to the evolving dynamics of the U.S. economy and global markets.

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