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U.S. small cap stocks poised for more gains

The Stock: iShares Russell 2000 Index Fund - CAD Hedged

Recent price: $17.80

The Trend

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Canadian investors have enjoyed good returns during the current bull market, with the domestic stock market outperforming U.S. stocks throughout the period. However, the relative performance of U.S. equities has improved enough that Canadians should consider expanding their exposure south of the border. Of particular interest is the small-capitalization sector, which has been eclipsing the performance of the bigger stocks in the S&P 500 index since the end of the third quarter last year.

The Russell 2000 index is the traditional benchmark for U.S. small-cap stocks. It is up 14 per cent from three months ago, ahead of the 11-per-cent advance in the broader U.S. market. About 35 exchange-traded funds offer various ways to play the U.S. small-cap sector. Last week, all but two of these ETFs reached new 52-week highs, including the heavily traded iShares Russell 2000 as well as the top-performing Vanguard Small Cap Growth fund, up 17 per cent in the past three months.

Small-cap Canadian equities are also doing well, signalled by the TSX Venture Exchange index outpacing the S&P/TSX composite index by 9 per cent during the winter's stock market advance. However, small-cap stocks on the Venture Exchange and the TSX are largely resource plays, so their recent performance premium is largely a reflection of the speculative strength of the commodity trade.

The Trade

The relative strength of the U.S. market may seem inviting to Canadian investors, but currency risk is a real concern. A strong and rising loonie eats away at the returns from U.S. stocks. But the iShares Russell 2000 CAD Hedged index fund, traded on the Toronto Stock Exchange, hedges its currency exposure and provides insurance against the chance the loonie may continue to rise.

An example of the hedging advantage of this fund can be found when comparing the performance of the unhedged Russell 2000 index against this iShares fund. Over the past three months the Russell's 14.3-per-cent gain would have been partially offset by a 2.3-per-cent rise in the Canadian dollar versus the greenback and resulted in a 12-per-cent return. In contrast, an investor in the Shares Russell 2000 index CAD Hedged fund would have retained a 13.1-per-cent gain.

The Upside

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The Russell 2000 is just 4 per cent shy of its pre-recession high. Trend investors can expect a bullish stock market to help blast through that long-term overhang and will be anticipating a 10-per-cent gain from the current level as the index moves along its current trend line.

The Downside

All the factors that threaten the U.S. stock market can doubly affect small-cap stocks. A surging U.S. dollar also means bad news for this trade, since Canadian-dollar-hedged instruments lag the unhedged index when the loonie drops. This fund would turn Stock Trends Weak Bullish at $16.50, a possible exit point for this trade if the market turns.

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About the Author
Skot Kortje

Skot Kortje has been analyzing stock market trends for 15-years using trend analysis. His Stock Trends indicators have been published by The Globe and Mail since 1995. More

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