Investment Idea: US Equity Small Cap Index

Small-cap equities refer to publicly listed stocks with a market capitalization typically ranging from $250 million to $2 billion. These companies often exhibit higher leverage and greater volatility, making them riskier investments. However, they also offer significant upside potential, especially in favorable economic conditions.

We believe smaller companies have a substantial chance of outperforming their larger peers in the next 6 to 12 months due to current economic conditions and attractive valuations.

Why Small Caps Now?

  1. Economic Conditions. Small-cap equities face disadvantages in the debt capital market compared to larger counterparts, with their capital structure leaning more heavily towards debt. This makes them more sensitive to changes in interest rates and the economic cycle.

 

With slowing inflation, cooling employment, and decreasing interest rates in some developed economies, the Federal Reserve is expected to lower interest rates soon.

Small-cap companies are poised to benefit from decreasing rates, as this would reduce their cost of capital and ease debt interest expenses. Nearly half of the debt held by small-cap companies is subject to floating interest rates, making them prime beneficiaries of lower borrowing costs.

  1. Valuations: The forward price-to-earnings ratio for the S&P SmallCap 600 index (15.5) is currently lower than its 10-year average and stands at a discount compared to the S&P 500 (23.7).

 

The valuation multiples for small caps haven’t been this low since 1999, a period that witnessed some of the most favorable conditions for small-cap equities in the following decade.

 

In terms of performance, small-cap stocks have notably underperformed their large-cap counterparts, especially in the last 15 months.

  1. Growth Trends: Investing in smaller companies provides exposure to various structural growth themes beyond artificial intelligence (AI), such as the energy transition, healthcare disruption, and water scarcity. Many smaller companies are active in these high-growth sectors, offering investors unique opportunities.

 

The Best Way to Invest in Small Caps

The Russell 2000 is the most well-known index for US small caps, but is it the best-performing? Let’s compare the three most popular indices covering this segment:

  • Russell 2000 Index, tracked by iShares Russell 2000 ETF
  • S&P SmallCap 600 Index, tracked by iShares Core S&P Small-Cap ETF
  • CRSP US Small Cap Index, tracked by Vanguard Small Cap

 

Surprisingly, the Russell 2000 is the worst-performing index among the three. On average, the total return gap between the Russell 2000 and the S&P 600 is over 1.2%, with an even larger difference compared to the CRSP index. This performance difference is due to how small-cap indices are constructed, as there isn’t a single definition for what qualifies as a small-cap company.

 

Risks of Investing in Small Companies

Contrary to the popular belief in the “small effect” or “size factor,” small- and mid-cap stocks do not consistently outperform large-cap stocks like those in the S&P 500 over the long term. Since the mid-1980s, returns for small and large caps have been on par.

Small caps are also more volatile compared to larger indices like the MSCI World, which has a median constituent size of $15 billion versus $1 billion for the MSCI World Small Cap Index.

 

Maximum drawdowns (the largest peak-to-trough declines) are also less favorable for small caps. Since 2020, the largest drawdown for the S&P 500 was about 7% less than that of the Russell 2000, with the S&P 500 also experiencing quicker recoveries.

Given these facts, small-cap equity indices are currently best suited for opportunistic allocation in an investment portfolio.

With promising macroeconomic dynamics, we believe that the time to invest in small-cap stocks is ripe.

Optimizing Risk with a Quality Index ETF

Investors can optimize risk-adjusted returns by investing in the most profitable companies within a small-cap index. This approach allows for exposure to low-capitalization stocks while increasing yield for similar risk.

Since 2018, Quality US Small Cap indices have delivered an annualized returns of 10% to 10.5% versus 6.2% of Russell 2000.

An outperformance of 4 per cent!

Over the past six years, our preferred small cap quality index has outperformed the Russell 2000 by more than 40%. These results show the value of prioritizing quality in less researched parts of the equity market.

By focusing on the most solid stocks within a small-cap index, investors can effectively navigate the complexities of this segment and achieve superior risk-adjusted returns.

 

Recap

  1. Small-cap equities are expected to outperform due to expected upcoming rate cuts and low valuations.
  2. Not all small-cap indices and ETFs are the same. The S&P and CRSP (Vanguard) indices have consistently outperformed the Russell 2000 with lower volatility.
  3. Investing in small companies is typically riskier compared to larger companies.
  4. Risk-adjusted returns of small-cap equities can be improved by selecting an ETF composed of the most profitable, high-quality names.
 
 

For more information on investing in US quality small caps, feel free to reach our investment team. 

Contact us 
Hubert Mrugala
Director – Portfolio Management
E-mail: hubert.mrugala@toledocapital.ch