The year 2015 was bumpy for the overall U.S. stock market which recorded the worst annual performance since 2008. The S&P 500 broke its three-year winning streak of double-digit gains but was far from the nearly 40% dive it took in 2008, while Dow Jones recorded its first annual decline in seven years.

Though the losses were somewhat broad based, the small caps underperformed even as the U.S. economy was on a modest growth path. This is especially true given that the Russell 2000 index lost nearly 5.2% in 2015 compared with losses of about 0.7% for the S&P 500, 2.3% for Dow Jones and 3.6% for the Mid Cap 400 Index. This trend is likely to reverse in 2016 as the Fed finally raised the interest rates, injecting abundant confidence in the U.S. economy (read: 16 Bold ETF Predictions for 2016).

In fact, the initial phase of rate hike is actually good for stocks as it reflects an improving economy and a lower risk of deflation. The small caps look to outperform, as these are free from the clutches of any global malaise and ensure higher return on improving economic health. These pint-sized stocks are closely tied to the U.S. economy and generate most of their revenues from the domestic market, making them safer bets than their large and mid-cap counterparts.

Further, the current beaten down prices reflect a good entry point for investors planning to play on the growing economy. As such, a few small cap ETFs and stocks have held up strongly in the market turmoil and are crushing the Russell 2000 index. Below, we have presented those that are likely to continue their strong performance heading into 2016 given that the same headwinds will persist:

Best ETFs

PowerShares S&P SmallCap Health Care Portfolio ((PSCH - ETF report))

This fund provides exposure to the health care sector of the U.S. small cap segment by tracking the S&P SmallCap 600 Capped Health Care Index. Holding 73 securities in its basket, the fund is widely diversified across components with each holding less than 4.2% share. From an industry look, about one-third of the portfolio is allotted toward health care equipment and supplies followed by health care providers and services (23.4%) and pharmaceuticals (17%).

The ETF is relatively unpopular, having amassed $276.8 million in asset base and trading in lower volume of about 36,000 shares per day. It charges 29 bps a year from investors and gained 20.3% in 2015. The fund has a Zacks ETF Rank of 1 or ‘Strong Buy’ rating with a Medium risk outlook (see: all the Small Caps ETFs here).

PowerShares S&P SmallCap Utilities Portfolio ((PSCU - ETF report))

This ETF targets the utility sector and follows the S&P SmallCap 600 Capped Utilities & Telecom Services Index. It holds a small basket of 19 stocks with concentration on the top firm – Piedmont Natural Gas (PNY) – with 14.5% share while other firms hold no more than 8.36% of assets. Gas utilities make up the largest chunk in the portfolio at 46.6% while diversified telecom services and multi utilities round off the top three with double-digit exposure each.

PSCU is often overlooked by investors as depicted by its AUM of $56.4 million and average daily volume of 19,000 shares. Expense ratio came in at 0.29%. The fund added nearly 6% last year and has a Zacks ETF Rank of 3 or ‘Hold’ rating with a medium risk outlook.

PowerShares S&P SmallCap Information Technology Portfolio (PSCT - ETF report)

This fund tracks the S&P SmallCap 600 Capped Information Technology Index. It has amassed $414.3 million in its asset base and trades in average daily volume of about 41,000 shares. The ETF charges 29 bps in fees per year from investors. Holding 104 securities in its basket, the product is well spread across securities with none holding more than 3.36% share.  

From an industry look, about one-fourth of the portfolio is allocated toward electronic equipment, followed by semiconductors (22.1%) and software (15.8%). The product gained over 4% last year and has a Zacks ETF Rank of 3 with a High risk outlook (read: Top Tech ETFs of 2015: The Best from a Winner).
 
Best Stocks
 
We have used our Zacks stock screener to find out the best performing stocks in the small cap space and then narrowed down the list of the stocks having a Zacks Rank #1 (Strong Buy), 2 (Buy) or #3 (Hold) and a Growth Style Score of ‘B’ or better.

The Growth Style Score analyzes the growth prospects of a company following a thorough analysis of the income statement, balance sheet and cash flow statement that evaluate its financial health and the sustainability of its growth trajectory. The results show that stocks with Growth Style Scores of A or B when combined with Zacks Rank of 1 or 2 offer the best upside potential.

Neophotonics Corp. ((NPTN - Snapshot Report))

San Jose-based NeoPhotonics is a leading designer and manufacturer of hybrid photonic integrated optoelectronic modules and subsystems for bandwidth-intensive, high-speed communications networks. The stock soared nearly 221% last year and has a Zacks Rank #1 with a Growth Style Score of A. It has an above-market growth rate of 167.3% for fiscal 2015 and 33.3% for fiscal 2016 with earnings estimates for both years moving in the upward direction over the past 60 days.

Recro Pharma Inc. ((REPH - Snapshot Report))

Malvern-based Recro Pharma is a clinical stage specialty pharmaceutical company that is engaged in developing non-opioid therapeutics for the treatment of pain. The stock gained nearly 215% last year and a Zacks Rank #2 with a Growth Style Score of A. It saw solid earnings estimate revisions over the past 60 days for both fiscal 2015 and fiscal 2016. Earnings estimates bettered from -$1.18 to -$1.16 for fiscal 2015 and from -$4.50 to -$2.78 for fiscal 2016 (read: Top Sectors of 2015 and Their Leading ETFs). 
 
LightPath Technologies Inc. (LPTH - Snapshot Report)

Orlando-based LightPath Technologies is a recognized leader in optics and photonics solutions engaged in designing, developing, manufacturing, and distributing optical components and assemblies. LPTH, with a Zacks Rank #1 with a Growth Style Score of A, surged about 211% last year. This stock also saw solid earnings estimate revisions of 220% for the current fiscal 2016 and 143% for the next fiscal 2017.

Bottom Line

These ETFs and stocks have shown strong resilience to the sharp downturn in the small cap space. This trend is likely to continue, making these lucrative picks for 2016, as small caps are considered the barometer of the domestic economy and are poised for accelerated growth following the rates hike.