Unwrapping the good things that come in small (cap) packages

In the final weeks of 2023, stocks and bonds both rallied, and the rise in share prices of US small-capitalization companies—at long last—added to the holiday cheer. The small-cap Russell 2000 Index surged 12% in December (ending the year +15%) and outperformed larger caps (as measured by the S&P 500), which rose about 4.5% for the month.¹ We believe the uptick may signal a turnaround for the small-cap space, following a rough decade during which smaller companies significantly trailed their large-cap peers by nearly 4% per year, on average.²

For much of last year, regional bank share prices slumped as investor sentiment for the segment soured due to the spring banking crisis and higher interest rates, and this disproportionately affected small caps. Given smaller companies’ relative reliance on shorter-term debt, they generally suffered from elevated borrowing costs more so than large caps did. Meanwhile, the rising artificial intelligence (AI) trend boosted tech giants, leading the S&P 500 to close out the year with a gain of more than 24%.

But the good news is that, in our analysis, small-cap valuations are now trading at an attractive discount to the S&P 500 and the Russell 1000. Prospects for a potential end to the rate-hike cycle, signs of cooling inflation and a robust labor market all provide tailwinds for small caps both in absolute and relative terms. Investors seeking to gain exposure to size-risk premium—the additional return expected by investing in small-cap stocks compared to large-cap stocks—can choose a higher allocation to funds focused on the small-cap segment. The small-cap stock premium (size effect) is one of the few effects that tends to find consensus support among researchers. The seminal academic findings of financial economists Eugene Fama and Kenneth French,³ based on decades of stock market history, showed that over time, companies with smaller market capitalizations had outperformed the overall market. The theoretical rationale that emerged was that of a size advantage, meaning smaller-cap companies—being more volatile or riskier—over longer periods also tended to better compensate investors for their additional risk. This is often also referred to as the size anomaly associated with factor investing.

While size-based strategies have been employed for decades since then, index provider MSCI notes in a paper on factor investing that only in recent years have transparent, rules-based indexes provided effective ways to expose portfolios to the size premium.⁴

Generally, the tendency for smaller companies to have longer runways for growth and greater flexibility during the business cycle can support the “size effect” premium.

If you’ve been seeking a diversification boost to remedy “Magnificent Seven”—Amazon, Alphabet, Apple, Microsoft, Meta, Tesla and Nvidia—overexposure, remember that the universe of small-cap companies covers a wider breadth of sectors and industries. Allocation to nimble, smaller companies with greater expansion opportunities than their larger counterparts could provide early access to future leading businesses.

Like US mid-cap indexes, small-cap indexes tend to be overweight in industrials. This is a sector that is arguably ramping up following government stimulus plans that include the US$1 trillion Infrastructure and Jobs Act (2021), clean energy spending related to the Inflation Reduction Act (2022), and the CHIPS and Science Act (2022), which is poised to strengthen American manufacturing, supply chains and a range of technologies.

Of course, there are inherent risks to investing in this asset class, such as the likelihood of encountering greater exposure to illiquid, lesser-known names with little to no analyst coverage. What’s more, some 40% of Russell 2000 Index companies have negative earnings.⁵

Investors seeking solutions that can offer a smoother, long-term experience may find multifactor exchange-traded strategies a better way of accessing solid risk-adjusted returns for small caps. Such approaches, like that of the LibertyQ US Small Cap Equity Index, screen for quality, value, momentum and low volatility to help weather the market volatility of the small-cap universe. For the 12 months ended December 31, 2023, value and quality were the main drivers of returns for the Index and its return on equity (ROE) was 4% higher than the Russell Small Cap Index.⁶

After years of underperformance, investors may find 2024 an opportune time to reassess their small-cap exposure.