The merits of staying small in today’s small-cap equity market
Our research shows that several U.S. small-cap strategies have recently strayed from their core market segment to go up in market capitalization. While such flexibility has in some instances yielded a relative performance edge, we view such an approach as problematic, as it runs the risk of deviating from investors’ portfolio allocation objectives at a time when we see a favorable valuation and fundamental environment for small caps.
To understand the current temptation for small-cap strategies to reach higher in market cap, it’s important to understand how we got here. History shows that it’s typical to see periods of relative outperformance by U.S. large- or small-cap stocks run for a decade or more, and the current dominance of large caps has now extended well beyond average. As of the end of 2023, large caps’ returns had outperformed those of small caps each calendar year since 2011—a 13-year run that exceeds the 11.5-year average for leadership by either large or small caps dating to 1932.
The current market leadership cycle between small and large has run longer than usual
Duration and magnitude of performance leadership cycles comparing U.S. large- and small-cap equities, 1932–2023 (%)
In the most recent stretch of the current large-cap run, bigger truly has been better—often by wide margins.
Bigger has been better: larger stocks have outperformed smaller ones by wide margins in recent years
Trailing returns for the 1-, 3-, and 5-year periods ended 3/31/24 for Russell equity indexes tracking 5 different market cap levels (%)
Despite the overall positive performance for each of the major market capitalization groups over the five-year period, it’s undoubtedly been frustrating for investors in strategies at the smaller end of the market cap spectrum to consistently lag. As for managers of small-cap strategies, they may gain a temporary performance edge by opportunistically reaching into the mid-cap realm in their stock selection; however, in our view, they also risk running afoul of their mandates to provide small-cap exposure and could create unintended overall portfolio risks for investors.
Recent examples of small-cap strategies not living up to their names
While instances of upward market cap drift are to be expected from time to time, our team has recently noticed what we consider to be an unusually large number of small-cap strategies reaching higher. This phenomenon is easy to see when considering the weighted average market cap of a common small-cap benchmark, the Russell 2000 Index (Russell 2000), was $4.7 billion as of March 31, 2024.1 Generally, most small-cap strategies seek to keep the average market cap of their equity holdings reasonably close to the benchmark’s average.
Yet our reviews of U.S. small-cap core strategies in both the institutional investor market and in the retail investor arena found many with weighed average market caps that have recently risen well above what we would consider appropriate for a fund that calls itself a small-cap strategy. Our search using the eVestment database found one strategy in the group with a weighted average market cap of $8.6 billion as of March 31, 2024—nearly $4 billion above the Russell 2000’s average. Two other institutional examples had averages of $8.0 billion and $7.2 billion; both of those strategies increased their weighted average market caps at a faster rate than the index did during the market rebound that followed the early 2020 emergence of the COVID-19 pandemic and during the 2022/2023 market decline/rebound cycle. In addition, our analysis of more than 140 mutual funds in Morningstar’s small-cap core category revealed a wide range of weighted average market caps at the end of March, from as small as $500 million to as high as $8.6 billion.
Three recent examples of institutional U.S. small-cap strategies drifting upward in market cap
Weighted quarterly average market capitalizations ($B) of selected institutional U.S. small-cap equity strategies versus the Russell 2000 Index, 1/1/19–3/1/24
Two small-cap index constituents have had a big effect on the category’s recent results
Recent instances of small-cap strategies straying into mid-cap territory have produced wide performance variations within the small-cap category, given the outperformance of mid- and large-cap indexes relative to their small-cap peers the past few years. While it’s normal for stock selection to be the key driver of performance differences within the group, we believe that much of the recent variation can be attributed to an anomaly that has heavily influenced relative performance. Some small-cap strategies have enjoyed a substantial relative boost as a result of their overweight exposure to two information technology sector stocks that outperformed the Russell 2000 by wide margins in late 2023 and early 2024.
In a similar fashion as the better-known Magnificent Seven that have recently led the large-cap segment, the extreme gains for these two smaller stocks—Super Micro Computer, Inc. and MicroStrategy, Inc.—resulted in this duo accounting for a rapidly growing share of the small-cap segment’s overall market cap. Super Micro and MicroStrategy were the Russell 2000’s top two index constituents as of April 30, 2024, and their combined index weight of around 3% represented the largest two-stock weight in the index’s 40-year history, according to our analysis of data from index provider FTSE Russell. (Despite its large weighting, Super Micro Computer remained an index constituent as of May 2024, as FTSE Russell’s next annual rebalancing of the index wasn’t scheduled to take effect until July 1, 2024. Another index provider, S&P Dow Jones Indices, added Super Micro Computer to its S&P 500 Index (S&P 500) on March 18, 2024).
Why actively managed strategies shouldn’t deviate too far from their benchmarks
How far is too far for a strategy to deviate from its market cap focus as reflected in the strategy’s name? There’s no simple answer, as being different from the benchmark is a necessity for generating relative outperformance. That said, investors have a right to expect that the individual strategies that make up their overall portfolio allocations operate within certain expected parameters as to market cap, equity style, and other market dimensions. Without such stability and predictability, an overall allocation can end up straying far from the investors’ objectives and cause unintended risks for an overall allocation profile.
Current risks from being too big in market cap to be considered a small-cap strategy
Within small caps, the flexibility to deviate at the market cap level can afford a performance edge, as has been seen recently for many strategies that gravitated upward in market cap. However, we view such approaches as potentially problematic now, given the abundance of untapped potential that we currently see in smaller stocks and the challenges that many higher-market cap small-cap strategies may have pivoting down to smaller-weighted average market caps as performance leadership eventually rotates away from recent large-cap dominance.
The traditional small-cap segment appears to us to offer strong potential, and we currently see three tailwinds that support the overall favorable outlook for the asset class:
1 Historically attractive valuations—Small caps’ recent underperformance relative to large caps has left the Russell 2000 close to its most inexpensive level relative to large caps in more than two decades, dating to the period when the technology stock bubble burst in 2000. As of April 30, the index’s relative price-to-earnings ratio based on the past 12 months of earnings was 0.63 as measured against the S&P 500. While that figure was up modestly from a recent low of 0.51 as of June 30, 2023, the more recent relative valuation difference nevertheless made small caps far less expensive than their long-term average of 0.92 dating to January 1, 1998.
Relative to large caps, small caps have recently traded at their lowest valuations in more than two decades
Relative valuation of the Russell 2000 Index versus the S&P 500 Index as measured by trailing price-to-earnings ratios, 1/31/1998-4/30/2024 (%)
2 Small-cap earnings outlook—We believe that small-cap earnings are likely to continue improving through the rest of 2024 and well into 2025. While analysts’ consensus estimate for a 9.8% year-over-year earnings growth rate in 2024 for the Russell 2000 Index lags the S&P 500’s projected 10.7% figure,2 we could see earnings growth leadership flip to small caps in a big way in 2025. In the year ahead, the Russell 2000’s earnings are forecast to grow 25.1%—almost double the projected 12.7% growth rate for the S&P 500.2
3 Forgotten asset class—We consider small caps to be an underowned asset class, given the fact that small-cap mutual fund flows have not only lagged other major fund categories, but have actually been negative overall dating to the March 2009 market trough during the global financial crisis. We consider small caps to be an ideal asset class in terms of the opportunities they present for bottom-up active fundamental investing, and we believe that greater recognition of these opportunities will eventually usher in an era of positive flows, which would provide support of asset prices across small caps broadly.
The U.S. small-cap equity category has been an outlier, with negative fund flows since the global financial crisis
Net asset flows for long-term U.S. mutual funds and exchange-traded funds, 3/1/09-3/31/24 ($B)
Risks to small-cap outperformance potential
While our team maintains a positive long-term outlook for small caps, several near-term headwinds pose risks that complicate the outlook through the rest of this year and perhaps beyond. Chief among them is the path that inflation takes through the end of this year and the pace of any further delays in rate cuts that the U.S. Federal Reserve may approve. Any additional extension of today’s elevated borrowing costs could disproportionately weigh on those smaller companies that are dependent on credit to grow. In this environment, we favor stocks of idiosyncratic, high-quality companies that can grow their earnings but also weather an economic downturn, should one materialize.
Small caps for the long run
Despite these current risks, we see an abundance of many high-quality smaller companies with strong fundamentals and resilient balance sheets. Given these bottom-up opportunities and the historically low valuations across small caps broadly, we see a fertile current environment for active fundamental investing emphasizing a core small-cap approach, with blended exposure across the growth and value equity style spectrum. As for the temptation to reach higher in market cap, thanks, but we’re still seeing plenty of opportunities in small caps without having to stray outside what we currently see as a hospitable small-cap neighborhood.
1 FactSet, April 2024. The Russell 2000 Index tracks the performance of 2,000 publicly traded small-cap companies in the United States. It is not possible to invest directly in an index. 2 Furey Research Partners, FactSet, as of May 10, 2024.
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The Russell 2000 Index tracks the performance of 2,000 small-cap companies in the United States. The S&P 500 Index tracks the performance of 500 of the largest companies in the United States. Market capitalization is the value of a corporation determined by the market price of its issued and outstanding common stock. Trailing price to earnings (P/E) is a valuation measure comparing the ratio of a stock’s price with its earnings per share over the past 12 months.
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