3 Risk-On ETFs That Are Underperforming

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Source: Thinkstock

Source: Thinkstock

One thing that investors should look at when trying to determine the overall direction of the stock market is the performance of “risk on” assets. These are assets that people want when they feel confident that the economy is strong and that people are spending more money. Some examples include:

  • Small cap stocks
  • Financial stocks
  • Growth stocks
  • Retail stocks

It is pretty evident why many of these asset classes outperform during “risk on” periods. When times are good, people are borrowing more money and spending it. This, in turn, entices businesses to expand, project more growth, and borrow more money in order to fund this growth. Small cap companies don’t intuitively fit this mold at first glance, but consider that small companies have more substantial growth potential, and this potential is often built into stock prices before it becomes a reality.

Investors who have been watching these sectors have noticed that they are underperforming. This is a sign that the risk on trade is over — at least for now. The bad news is that this could mean that there is trouble ahead for the global economy. This shouldn’t surprise anyone, especially since the economy enters a recession every 4 to 6 years. The good news is that there are clear signs out there, and if you follow them you can prepare yourself by reducing your equity exposure and by buying safe haven assets such as Treasuries, gold, or even inverse ETFs that rise in value if the stock market falls.

A good way to follow these signs is to look at the performance of certain ETFs. ETFs have made it very easy for retail investors to see what is going on with certain asset classes and to make decisions based on these observations without having to compile a seemingly endless amount of data. Here are three ETFs that I follow that suggest to me that we are transitioning from a “risk on” period to a “risk off” period.

1. The iShares S&P Small Cap 600 Growth ETF (NYSEARCA:IJT)

This is an excellent fund to put on your watch list because it satisfies two of the categories I mention above — small cap stocks and growth stocks. The IJT filters through the S&P 600 — S&P’s small cap index — in order to locate growth stocks. These companies are going to be economically sensitive, and they are going to leverage your exposure to the stock market. If the stock market is rising, IJT will outperform, and if the stock market is falling, then IJT will underperform.

While the S&P 500 has been more or less flat on the year, the IJT is down 5 percent. This underperformance suggests to me that investors are becoming risk averse, and that they are less willing to hold these more volatile stocks. By comparison, if we look at a large-cap value ETF such as the iShares Russell 1,000 Value ETF (IWD), we find that this asset class is up 2 percent for the year, which means the difference is 7 percent. This is a big deal, and it indicates that growth is slowing and that investors want to own large companies — which are typically more stable than small companies — that trade at low valuations.

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