Small-cap stocks' impressive rally off the March 2020 low should have financial advisers rethinking portfolio allocations heading into a year in which smaller companies could continue to lead.
The key, however, will be choosing wisely between active and passive strategies, and even being selective among the index fund offerings.
“Small caps have led since the new bull market began in March and that was confirmed in a huge way coming out of the October bottom,” said Paul Schatz, president of Heritage Capital.
“What we have seen since then has been a powerful thrust which we often see when new trends emerge,” Schatz said. “While small caps may pause their leadership for a few weeks or a few months, I would buy any and all dips versus large caps. This is a seminal market change.”
Small-cap stocks, which tend to be more cyclical and more volatile, have eclipsed the performance of the stocks of larger companies by most measures over the past nine months.
The Russell 2000 index is up more than 106% from the March 2020 bottom, which compares to a 66% gain for the S&P 500 Index over the same period.
Since Nov. 18, when Pfizer announced the first major COVID-19 vaccine breakthrough, the small-cap index has gained 14%, while the large-cap S&P 500 gained 6%.
“Small-cap stocks got a figurative shot in the arm in mid-November following the announcement of favorable vaccine trial results from Pfizer and Moderna,” said Ben Johnson, global director of ETF research at Morningstar.
“The prospect of reopening large parts of the economy lifted shares of companies that thrive under our pre-2020 ways of living and working,” he said.
The disparity was evident during the first trading week of the year, when small caps were up 5.6%, compared to 2% for large caps.
Bob Doll, portfolio manager and chief equity strategist at Nuveen, listed the strength of small caps versus large caps in his popular list of 2021 predictions.
“Small caps tend to be more cyclically oriented than big-cap companies and therefore smaller company earnings gains will be superior to large caps,” Doll said. “And if you look at the valuation levels, they’re cheaper on the small side. This is a probability business, so if you line that all up, my guess is small beats big this year.”
Francis Gannon, co-chief investment officer at Royce Investment Partners, also sees small caps benefitting from a reversion to the mean, “even if it doesn’t happen in a straight line.”
“The strength of small caps is driven by the broadening of the overall economy and earnings expansion that will be faster for small caps than large caps,” he said.
Gannon, who has a dog in the fight as the CIO of a firm managing $14 billion worth of small-cap fund assets, believes the strong finish for small caps in 2020 is indicative of things to come.
“Our thought process is the market has been looking through to other side of COVID, and hopefully returning to some kind of normal,” he said. “One of the more exciting areas are cyclicals, or anything economically sensitive. Defensive stocks look expensive.”
In terms of the best way to access the small-cap space, Gannon believes the time is ripe for active managers, particularly considering such abnormalities as the fact that almost half the companies making up the Russell 2000 Index are not profitable. The long-term average for companies in the Russell index that aren't showing a profit is around 30%.
“The index has got some risk in it,” Gannon said.
However, as Morningstar’s Johnson points out, not all small-cap indexes are created equal.
While the Russell 2000, which can be accessed through the iShares Russell 2000 ETF (IWM), might offer broad market exposure, there are plenty of varieties of small-cap exposure.
The iShares Core S&P Small Cap ETF (IJR), for example, tracks the S&P 600, which requires four consecutive quarters of positive net earnings prior to inclusion into the index. The fund is up 96% from the March low.
Another example of small-cap index exposure is the Vanguard Small Cap Value ETF (VBR), which tilts slightly toward more mid-cap companies and is up 91% from the March low.
As Johnson puts it, “some of the nuances can have meaningful implications.”
In essence, the more small cap oriented an index is, the more its performance is linked to the beta of what’s going on in the economy, and that typically means volatility.
“It’s the reverse of common logic, but when it comes to stocks, the smaller they are the harder they fall, which also means leverage to the upside,” Johnson said.
Whether exposure to small caps is through actively managed or passive index strategies, Johnson said advisers should know exactly what they’re buying.
“At the end of the day, it’s the beta doing most of the heavy lifting,” he said. “You’ll get a lot just by favoring that segment of the market, and it’s difficult to say who will pick best of breed better than anyone else.”
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