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Many of us will have seen our Stocks and Shares ISAs capture strong gains over the past six months. Markets have generally moved higher, and for those with diversified portfolios, that progress is likely reflected in healthier account balances.
With that in mind, it may surprise some — though perhaps not all — that there are investors actively positioning for weakness.
One notable example comes from the political world. Congressman Tim Moore, who sits on the US House Committees on Financial Services and the Budget, has been making sizeable purchases of TZA (NYSEMKT:TZA), a three-times-leveraged bear ETF (exchange-traded fund) designed to move inversely to the Russell 2000 Index of smaller US companies.
In effect, when the Russell 2000 falls 1%, TZA rises around 3%. Moore’s trades highlight that not everyone is convinced the rally will last, particularly in more vulnerable and volatile small-cap names. His trades were made in late August and amount to as much as $215,000.
A little more on TZA
At its core, TZA is a way to profit when smaller US companies stumble. The Russell 2000 Index is often more sensitive to economic pressures than the S&P 500, given its heavier tilt toward domestically focused businesses with thinner margins. By offering three times the inverse daily return, TZA can appeal to investors who believe tougher conditions are ahead for small caps.
For example, if borrowing costs remain high and credit tightens, smaller firms could feel the squeeze first. That scenario might tempt short-term speculators into products like TZA. Of course, the leverage cuts both ways — a rally in small caps could mean sharp losses for anyone holding the fund.
Is betting against smaller companies a good idea?
Small-cap companies are generally more vulnerable to higher interest rates, as they rely heavily on borrowing and have limited pricing power compared to large caps.
With US rates still elevated and financing conditions tight, many smaller firms face margin pressure and refinancing risks. In addition, slowing economic growth tends to hit domestically focused businesses hardest, while large multinationals can lean on overseas revenues.
Valuation also plays a role. Despite underperformance, small caps remain relatively expensive based on forward multiples given weaker earnings momentum. Remember, 43% of small caps are unprofitable.
The TZA ETF offers a leveraged way for contrarian investors to express a bearish view that small caps could continue to lag if rates stay higher for longer or a downturn emerges.
Worth considering?
I don’t typically believe that betting against the market is a good idea. After all, the stock market has delivered positive returns over the long run. And over the past five years, this fund’s share price has fallen 94%.
However, there is some evidence that US small caps could struggle in the current and rather unpredictable environment. With that in mind, it’s worth considering, although the longevity of the investment could be questionable. It’s on my watchlist.