Unpack the good things that come in small (cap) packages
Shahrir Maulana
Dina Ting, CFA, Head of Global Index Portfolio Management, Franklin Templeton ETFs
The surge in small-cap performance in the final weeks of 2023 may signal a long-awaited turnaround for small-cap stocks that have lagged their large-cap peers. For 10 years, according to Dina Ting, head of global index portfolio management. She analyzes the struggles small-cap stocks have faced over the past year and why she believes they now offer potentially attractive opportunities in 2024.
Both stocks and bonds rebounded in the final weeks of 2023, and finally, rising stock prices of small and medium-sized U.S. companies added to the holiday spirit. The small-cap Russell 2000 index surged 12% in December (+15% year-to-date) and outperformed large-cap stocks (based on the S&P 500) by about 4.5% for the month.One We believe that an uptrend can send a signal The small-cap sector’s turnaround comes after smaller companies have lagged their large-cap peers by a significant margin, averaging nearly 4% per year over the past decade.2
Shares of regional banks fell for most of last year as the spring banking crisis and rising interest rates dampened investor sentiment in the sector, which disproportionately affected small-cap stocks. Given small companies’ relative reliance on short-term debt, they are generally more likely to suffer from rising borrowing costs than larger companies. Meanwhile, the S&P 500 finished the year up more than 24% as the artificial intelligence (AI) trend boosted tech giants.
But the good news is that our analysis shows that small-cap valuations are currently trading at an attractive discount to the S&P 500 and Russell 1000. The prospect of a potential end to the rate hike cycle, signs of cooling inflation, and a strong labor market all provide tailwinds for small-cap stocks in both absolute and relative terms. Investors seeking exposure to the size risk premium (the additional return expected by investing in small-cap stocks compared to large-cap stocks) may opt for a higher allocation to funds that focus on the small-cap sector. The small-cap premium (scale effect) is one of the few effects that tends to find consensus support among researchers. Key academic findings from financial economists Eugene Fama and Kenneth French include:three Based on decades of stock market history, we have shown that over time, companies with smaller market capitalizations have outperformed the overall market. The rationale that emerged was the scale advantage. What this means is that smaller companies that are more volatile or riskier over the long term tend to offer investors a better return on the added risk. This is often referred to as the scale anomaly associated with factor investing.
Although size-based strategies have been adopted in the decades since, index provider MSCI notes in its paper on factor investing that in recent years transparent, rules-based indices have provided an effective way to expose portfolios to the size premium.4
The tendency of smaller companies to generally have longer runways for growth and greater flexibility over the business cycle may underpin the “scale effect” premium.
If you’re looking to boost diversification to address the “Magnificent Seven”—Amazon (AMZN), Alphabet (GOOG) (GOOGL), Apple (AAPL), Microsoft (MSFT), Meta (META), Tesla (TSLA), and Nvidia (NVDA) )—Overexposure, remember that the world of small businesses encompasses a wider range of sectors and industries. Allocating to nimble, small businesses that have more opportunities to expand than large corporations gives you early access to the leading businesses of tomorrow.
Like U.S. mid-cap indices, small-cap indices tend to be overweighted industrials. This is an area that is growing under government stimulus, including the $1 trillion Infrastructure and Jobs Act of 2021, the Inflation Reduction Act and Related Clean Energy Spending (2022), and the CHIPS and Science Act (2022). It is poised to strengthen America’s manufacturing, supply chain, and diverse technologies.
Of course, there are inherent risks to investing in this asset class, such as the potential for greater exposure to illiquid and lesser-known names with little or no analyst coverage. Additionally, approximately 40% of the Russell 2000 Index companies posted negative returns.5
Investors looking for a solution that can provide a more seamless, long-term experience may find that multi-level exchange trading strategies are a better way to access solid risk-adjusted returns on small-cap stocks. Approaches like the LibertyQ US Small Cap Equity Index help overcome market volatility in the small-cap world by screening for quality, value, momentum, and low volatility. Value and quality were the main drivers of index returns for the 12 months ended December 31, 2023, with return on equity (ROE) 4% higher than the Russell Small Cap Index.6
After several years of underperformance, investors may think 2024 is the perfect time to reassess their small-cap exposure.
What are the risks?
All investments involve risk, including the possible loss of principal. equity securities There is a possibility of price fluctuations and loss of principal. small and mid-cap stocks Stocks involve greater risk and volatility than large-cap stocks. But I can’t be sure. Multi-Level Stock Picking Processes improve performance. Exposure to these investment factors may reduce performance over an extended period of time in some market environments. active management It does not guarantee a profit or protect against market declines.
ETFs trade like stocks and their market value fluctuates, which may be more or less than the ETF’s net asset value. Brokerage commissions and ETF expenses reduce your returns. ETF shares can be bought or sold at market prices throughout the day on the exchange where it is listed. However, there can be no assurance that an active trading market for ETF shares will develop or be maintained or that their listing will continue or remain unchanged. Shares of ETFs may be tradable in secondary markets, but may not be readily traded in all market conditions and may trade at significant discounts during periods of market stress.
Commissions, management fees, brokerage fees and expenses may be associated with ETF investments. Please be sure to read the investment prospectus and ETF-related information before investing. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.
any Company and/or case studies Information mentioned in this document is for illustrative purposes only. All investments may or may not currently be held by portfolios advised by Franklin Templeton. The information provided is not individual investment advice or a recommendation for any particular security, strategy or investment product, and does not represent any trading intent for any portfolio managed by Franklin Templeton.
1. Source: Bloomberg. The Russell 2000 Index is a small-cap U.S. stock market index comprising the smallest 2,000 stocks in the Russell 3000 Index. Indexes are unmanaged and cannot be invested in directly. This does not include any fees, costs or selling costs. Past performance is not a guarantee or indicator of future performance. For additional data provider information, see www.franklintempletondatasources.com.
2. Same.
3. Fama, E. and French, K. “Common Risk Factors in Stock and Bond Returns.” Journal of Financial Economics. 1993.
4. Source: “Factor Investing – Factor Focus: Size.” MSCI. 2016.
5. Source: Bloomberg, FactSet. As of December 2023.
6. Source: Morningstar. As of December 31, 2023. The LibertyQ US Small Cap Equity Index is based on the Russell 2000 Index, a parent index that measures the performance of the small-cap sector of the US equity universe. The LibertyQ US Small Cap Equity Index is designed to reflect the performance of Franklin Templeton’s strategy, which seeks exposure to four factors: quality, value, momentum and low volatility. Indexes are unmanaged and cannot be invested in directly. This does not include any fees, costs or selling costs. Past performance is not a guarantee or indicator of future performance. For additional data provider information, see www.franklintempletondatasources.com.
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