Readers of this blog are well aware of my frustration with the performance of small- and mid-cap equities. The overwhelming dominance of the S&P 500 (IVV) over the past 15 years has dwarfed the middling performance of the small- and mid-cap universe (see chart below). Also, note that the S&P 500 has been relatively less volatile with less maximum drawdown than other diversifiers like U.S. small- and mid-cap equities and international developed and emerging market equities (SCHA, SCHM, SCHF and SCHE).
The investment press is abuzz with many reasons for this lengthy drought of underperformance. They include:
growing share of small cap (~40%) have no profits versus less than 10% in the S&P 500
a sustained drop in the number of publicly listed small firms over the past two decades (from ~8,000 in 1996 to ~4,200 by 2019) reduced the opportunity set and the ‘migration’ of winners into large-cap status
many attractive small-cap candidates remain private longer delaying when they impact small-cap indices
passive flows have increasingly favored large‑cap indices, especially with megacap tech leadership, reducing small‑cap demand
Market concentration—S&P 500’s “top 7” firms driving much of its gains—has reinforced large-cap dominance
In the academic world, some investment factors have been identified that overtly influence investment performance. Some of these factors include momentum, low volatility, quality, and, of course, small cap equities. Though there is a continuing debate on the validity of this phenomenon, stocks with these factors have been shown to tend to outperform over long horizons and market cycles; except when they don’t!
Certainly, the past 15 years has been a long horizon across many market cycles. Based on some of the structural changes identified above, the small cap factor may no longer offer the same return advantage it once did—at least in today’s environment.
Clients of D&A may have noticed a small bit of trading the last few weeks as we have trimmed small cap equity exposures from some client accounts. We expect that this reduction in a market sector that appears to be structurally impaired will help smooth portfolio returns relative to the broad global markets. We remain diversified across a range of global assets and will continue to adapt as markets evolve.