Why Now is the Time to Consider Strategic Small Cap Allocations
Adding or increasing an allocation to small-cap stocks could help institutional investors achieve a few common goals, such as potentially helping to boost short-term performance or improve diversification. The allocation to small caps could also help offset the potential reduction in expected return for liability-aware investors who increase fixed income securities in their portfolios to reduce risk.
Small caps should always be considered, but now might be a particularly good time to focus on the asset class. As the post-pandemic recovery continues, small caps are supported by attractive economic dynamics and relative valuations.
Small caps have historically performed well relative to their larger counterparts in the years following a recession. This is due, among other things, to the more oriented exposure to the domestic small cap market and higher operating leverage. Consider the dot-com bubble in the early 2000s. In the three-year period following this bear market, small caps1 outperformed large caps2 by 42%. A similar pattern recurred after the 2008 global financial crisis (GFC). In the three years since GFC, small caps outperform large caps by 32%.
While these past models are no guarantee of future performance, the stock market decline induced by the 2020 pandemic is no different from these two historic bear markets. Today’s small caps could be well positioned to deliver strong performance as the economic recovery from the Covid pandemic continues. In fact, during the third quarter of this year, small cap stocks outperformed their larger counterparts.
Small caps have been lagging large caps since spring 2021, as market leadership moved away from cyclical value-driven domains into more growth-oriented segments. This rotation was driven, in part, by concerns surrounding the economic recovery due to inflation and supply chain challenges. Still, there is good reason to believe that the cycle of small cap outperformance is not over – on the contrary, it may be just catching its breath.
On the one hand, the prospects for increased infrastructure spending are likely to favor sectors more widely represented among small caps, such as industrials, energy and utilities. In addition, companies have now accumulated high levels of liquidity, which we believe will lead to, among other things, increased capital spending and M&A activity – both of which should favor smaller stocks. capitalization. As inflation and supply chain issues subside over time, thus helping to increase spending and investment, small caps are well positioned to potentially lead markets higher.
Favorable valuations of small caps
While the economic momentum supports small caps, the relative valuations of the asset class are also very compelling. In fact, small caps are trading near their biggest discount to large caps in 20 years. The discount of small caps to large caps has increased in recent years, in part due to the different sector compositions of the US large and small cap indices.
For example, the S&P 500 Index has a significantly higher weighting in the Information Technology (IT) sector, a growth segment that has outperformed in recent years. On the other hand, the Russell 2000 Index has a higher weighting in the financial services sector, a more value-oriented sector that has performed relatively poorly. Notably, after small caps reached a similar level of âcheapâ in early 2001, stocks of small cap companies significantly outperformed those of large caps over the following three, five and ten year periods.3
Modeling done by abrdn suggests that moving a relatively modest 2% allocation from other public stocks to small caps could help improve risk and reward measures. According to abrdn, small cap stocks currently have an attractive expected return per unit of risk. Additionally, small cap stocks offer a diversification advantage as they do not correlate perfectly with other stocks in developed markets which generally have higher weightings within the portfolio.
Small cap and fixed income – an unlikely couple
Liability-aware investors who have or near-cap status might find particular use in a small cap allocation. It is common for these investors and others to want to reduce risk. A typical way to do this is to increase exposure to fixed income securities. But it is also common to fear a reduction in the expected return assumption as portfolios pivot towards larger fixed income allocations. abrdn sees a combined and complementary allocation to fixed income and small caps as a potential solution to this problem.
Increasing exposure to small cap stocks alongside fixed income securities could help mitigate the negative impact on expected return that this low risk fixed income investment could have.
The current expectation of 10-year return for small-cap stocks is 11%, compared to 6.4% for large-caps. The high return expectations for small caps could offset the drag that fixed income investments can have on the portfolio, potentially providing a very comfortable addition to a portfolio otherwise dominated by large caps. These two asset classes may form an unlikely pair, but they could potentially solve the risk reduction conundrum without reducing the expected return.
1 As represented by the Russell 2000 Index
2 As represented by the S&P 500 Index
3 As of January 31, 2001, the Russell 2000 futures P / E to the Russell 1000 was at a low of 0.73. Over the following 3, 5 and 10 year periods, the Russell 2000 returned 19.0% (vs. -13.1% for the S&P 500), 53.8% (vs. 1.9% for the S&P 500) and 75.2% (compared to 13.8% for the S&P 500). Source: FactSet
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The hypothetical performance of the portfolio is not an indicator of actual future results. There can be no assurance that the assumptions or projections used herein will be satisfied. abrdn often uses forecast and projection models to help derive estimated returns as well as volatility as part of its portfolio design and investment management processes. No projection or forecast can offer an accurate estimate of future returns or the volatility of asset classes or global markets. Forecasts are inherently uncertain, subject to change at any time based on various factors, and may be inaccurate. abrdn believes that the benefit of this information is greatest in assessing the risk-adjusted potential return of various components of a globally diversified portfolio. Projections or other information contained in this document regarding the likelihood of various investment risks and performance results are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Information provided for informational purposes only; is not indicative of any abrdn product; and no inferences are made with respect to future performance and / or investment results.
Abrdn’s forecast modeling integrates both proprietary and third-party tools to derive risk and return data for each asset class listed. Our forecasts and projections are based on history while making forward-looking assumptions. We use economic forecasts, implicit market views and assumptions about historical trends and mean reversion over multiple time horizons. We use various macroeconomic and asset class specific variables as inputs. In an attempt to predict expected returns and volatility, we apply a Monte Carlo simulation method to project the estimated volatility. This allows us to create 10,000 scenarios, from which we derive realistic probability distributions for returns, and from which the volatility of asset classes can be derived. The results produced by the forecasting tool will change with each use and over time. Further information regarding our predictive modeling can be provided on request.
Projections are offered as opinions and do not reflect potential performance. Projections are not guaranteed and actual events or results may differ materially.
Diversification does not guarantee a profit or protect against a loss in a declining market.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates can cause the market value of an investment to fall), credit ( changes in the financial position of the issuer, borrower, counterparty, or underlying collateral), early repayment (debt issuers may repay or refinance their loans or bonds earlier than expected), appeal (some bonds allow the issuer to call a bond for repayment before maturity) and extension (major repayments may not occur as quickly as expected, resulting in an increase in the expected maturity of a security).
Shares of small and mid-capitalization companies carry higher risk and greater volatility than shares of larger, more established companies.
The indices are not managed and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.