The theory behind investing in small-cap funds is reasonably clear: because of their small total values and the fact that they receive little, if any, analyst coverage, small-cap stocks offer the potential for impressive growth without the drawback of inflated prices.
In essence, small-cap funds assume that smaller stocks have greater potential for outperformance. The problem, however, is that such funds could be making other bets unknowingly — and hurting their own performance as a result.
One example, as reported in the Wall Street Journal, can be observed by comparing the Russell 2000, a commonly used small-cap benchmark, and the Russell 1000, a standard large-cap benchmark.
Citing Alec Young, managing director of global markets research at FTSE Russell, the report said that the financial sector, one of the poorest-performing sectors this year, has a 27% weighting in the Russell 2000 and just 21% in the Russell 1000. But the tech sector, one of the year’s best performers, has just a 13% weighting in the Russell 2000 and 22% in the Russell 1000.
“Through the end of August, Vanguard Russell 1000 ETF has markedly outperformed Vanguard Russell 2000 ETF—18.2% to 12.0%,” the Journal reported.
That means investors who want to pursue a pure small-cap play could not count on index funds that are benchmarked to small-cap indexes. Instead, they have to come up with a portfolio that, aside from being composed of small-cap stocks, is no different from the entire market.
It’s a challenge that’s worth the effort, maintained Kent Daniel, a finance professor at Columbia University and a former co-chief investment officer at Goldman Sachs. In an interview with the Journal, he said that creating a pure small-cap portfolio doesn’t end with hedging out differences in sector tilts.
Read also: The overlooked differences between factor investing and smart beta
For instance, because the Russell 2000 index currently contains stocks that are more volatile on average than those in the Russell 1000, investing in the Russell 1000 entails an implicit bet that high-volatility stocks will outperform low-volatility ones. A pure small-cap play should therefore also hedge out that assumption.
Factors such as geography, financial quality, profitability, and other “relevant respects” — a list that’s quite long — should also be balanced out, though Daniel said that industry and sector exposure is perhaps the most critical variable to hedge away. In a recently completed study, he and several other researchers managed to construct a fully hedged small-cap portfolio; its performance since 1963 has reportedly matched the unhedged version’s but with just half the risk. The same can be done for other recognized factors such as value.
As of now, there’s no ETF or mutual fund that implements Daniel’s approach. Those who’d like to apply his recommendations to their own portfolio should therefore actively hedge out the most extreme exposures of whatever factor portfolio they’re investing in; in the case of small-cap investors using the Russell 2000, it would mean shorting some stocks in financials and increasing their long bets on tech.
Follow WP on Facebook, LinkedIn and Twitter