WAndy Hyer is a client portfolio manager at Nasdaq Dowsey Wright. He discusses how small cap stocks performed over the past year compared to large caps and how small caps will perform under rising interest rates.
How did small cap stocks do in the last year? Do you expect their performance to change in the new year.
Below is a table that shows the performance of both the Russell 2000 Index (small caps), and the S&P 500, (large caps), in each year from 2007 to 2021. The chart below shows that small cap stocks have outperformed large caps stocks in the last 1, 3, 5, 10, and 15 years. This is quite a long stretch of underperformance by small cap stocks.
Data dating back 50 years show that small cap stocks outperformed large caps stocks by about 1% a year. This is according to finance theory. This suggests that small cap stock should generate higher returns than large stocks over long periods of money due to the higher risk associated.
Dorsey, Wright, as of 12/31/21. Only price returns are included, not dividends. An index cannot be invested directly by investors. Indexes do not charge fees. Past performance is not indicative for future results. There is always the possibility of losing money.
Investors are asking themselves whether we will see a reversion of the mean in the next few years, with small cap stocks moving back in favor relative large cap stocks. The answer is yes. Although no one knows what the future holds, the dynamic of smaller cap stocks outperforming larger cap stocks over the longer term and then the recent downturn in small cap performance suggests that it makes sense for asset allocation to ensure adequate exposure to small cap stocks for the possibility of a rebound.
Inflation and interest rates will rise even further in the new year. How do small caps fare in this environment?
Just recently, the Labor Department reported that inflation measured by CPI rose by 7% in 2021. This is the fastest pace in almost 4 decades. There is a constant debate about how sustainable this inflation will become. Economists argue that inflation will continue for some time, while others argue that inflation will decline.
The 10 Year Treasury Yield Index closed 2021 at 1.51%. This is an increase of 0.92% from the end 2021. It has also moved higher in the first two weeks of 2022.
Small cap stocks may perform better than large caps in an inflationary climate because it is easier for smaller companies in this environment to pivot and make adjustments. It has been suggested that smaller companies may be better able to raise prices and change where they source their goods and materials more quickly.
Although it is difficult to look back at historical periods of rising or falling inflation and predict how small caps will perform over the next few years, I believe we can draw a strong argument for small cap exposure being part of an asset allocation. Because of recent large cap outperformance, we have become complacent about other segments of market –like small caps—that may present good opportunities in the coming years. This is why I believe this topic is timely.
Are there any stocks or indexes in the small-cap space that investors should be particularly vigilant about?
Two ways investors might want to increase their small cap exposure are discussed below. The Invesco DWA SmallCap Matterum ETF (DWAS) is the first. This ETF is based on the Dorsey Williams Small Cap Technical Leaders index, which selects approximately 200 small cap stocks from a universe of approximately 2000 that meet our relative strength criteria. The index is rebalanced every quarter. This ETF has been around since 2012. More information on this ETF is available hereHere.
OurFusion Small Cap SMA is another way investors might consider small cap exposure. This was recently introduced. This separate managed account strategy is jointly managed and managed by RiverFront Investment Group (Nadaq Dorsey Wright) We are very excited about this new initiative between our firms. This strategy is based on an investment universe of approximately 2,000 small cap stocks in the United States. RiverFront provides quality and value scores for this universe, while Nasdaq Dorsey Wright provides momentum scores and volatility scores. These inputs are used for selecting the approximately 70-75 securities to be included in this portfolio.
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This information has not been tailored to meet any investor’s financial situation or investment objectives. Investors should not take any advice or recommendation contained in this material without consulting their financial advisors. The information contained in this document is based upon data from recognized statistical services, communications from issuers, or other reliable sources (information providers). DWA and information providers have not verified the information. DWA, the information providers and DWA make no representations or warranties and assume no responsibility for the accuracy and completeness of any information or recommendation contained herein.
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These views and opinions are solely the author’s and do not necessarily reflect the views of Nasdaq, Inc.