Tag Archive: volatility

Small-caps are gaining traction as light appears at the end of the COVID tunnel

After a long period of either underperformance or mixed relative returns, small-caps in the US are now finally gaining meaningful traction relative to large-caps.

As shown below, the relative return of the small-cap Russell 2000 index versus the large-cap Russell 1000 index has broken out of the range it has been in since June. The latest move started after the Pfizer vaccine news hit on November 9th, after making an initial move in early October.US Small-Cap Large-Cap Relative Return

Our view has long been that small-cap relative performance follows a cyclical pattern, with the best return/risk payoffs coming when the economic and market cycle have been weak and are starting to recover. The early stages of a new expansion or bull market are thus typically the best for small-caps, while the later stages of an expansion or the early phases of a bear market or recession tend to be better for large-caps, especially after accounting for risk.

The current economic cycle has been very unusual. After a record-long expansion, a very rare external shock (a virus) hit, causing far higher amplitude in the economic data (record-setting declines and recoveries), along with historically huge policy interventions (fiscal and monetary stimulus, etc.). The heavy uncertainty about how the current cycle will play out may explain why small-cap relative performance has only recently started to show the upturn we would expect as conditions start to improve after a recession. The recent signs of progress on a vaccine (or multiple vaccines) offer the prospect of “getting back to normal” next year, and may reduce some of the headwinds facing smaller companies relative to larger firms.

Several other indicators suggest the small-cap outperformance trend may be a better bet now than earlier this year.

First, US small-caps are outperforming across all sectors over the last month, indicating a broad-based trend. This includes the Technology sector, where large-cap Tech had outperformed small-cap Tech by 30% for the year through September 1st, but since then small-cap Tech has outperformed its larger brethren by 12%.

Second, as shown below, the “volatility penalty” for owning small-caps has declined and is now back to relatively low levels. The rolling three-month volatility of the Russell 2000 index has now fallen back to just a small differential over the volatility of large-caps (Russell 1000). That is, investors do not have to take on substantially more risk (volatility) in their portfolios by choosing small-caps over large-caps, as they would have done earlier in the year.US Small vs Large-cap Relative Volatility

And third, small-caps outside the US have been outperforming for some time now (as shown in the lower two sections of the chart below), and therefore US small-caps may have some catching up to do.Global Small-cap Relative Returns

With price activity looking better and the cyclical backdrop potentially becoming more favorable, there could be more room for the recent trend of small-cap outperformance to run over the coming months.

Relative volatility risk in US small-caps remains high

Among the various asset allocation decisions for which we provide guidance to clients is whether to favor small-caps or large-caps (i.e., the “size” factor) within the US equity market. In our view, small-caps do not reliably outperform large-caps consistently over time (as some models and studies might suggest), and instead view the “size premium” (outperformance of small-caps) more as a cyclical phenomenon that tends to show up under certain macroeconomic and market conditions.

While there are many potential conditions that might affect small-cap/large-cap relative performance, much of our work is oriented around the idea that small-caps give the best “bang for the buck” in the periods just before and through the early stages of a new economic or market cycle. That is, recessionary troughs in the economy and equity market set up the conditions for future small-cap outperformance, as smaller companies tend to benefit most from the re-acceleration of economic growth that typically occurs after recessions. This is also when monetary and fiscal stimulus tend to be strongest. In these scenarios, small-caps have typically underperformed before and during the preceding recession/bear market and become out of favor and potentially undervalued. Conversely, the later stages of an economic cycle and the early stages of a recession or bear market tend to be unfavorable for the riskier and more economically sensitive small-caps.

Looking at conditions now, there is certainly evidence that a recessionary trough has occurred or is in process, and both monetary and fiscal stimulus have been very aggressive. This would potentially argue for favoring small-caps over large-caps, and indeed small-cap relative returns have stabilized after a sustained period of significant outperformance by large-caps since mid-2018 (and arguably longer). However, it may be worth an extra dose of caution before making heavy overweight allocations to small-caps on an intermediate-term (6-12 month) basis. This is not only due to the unusual nature of the current cycle, but also more specifically to the extremely elevated relative risk still apparent in the volatility of small-caps versus large-caps.

Using the Russell 2000 Index to measure returns for US small-caps and the Russell 1000 Index for large-caps, the chart below shows the rolling three-month annualized volatility of daily returns for both indices over the last 20 years (small-caps in blue, large-caps in red) in the top section, and the difference between them in the bottom section.

US Small Large Cap Relative Volatility

A few things jump out: first, volatility for all equities surged to extreme levels earlier this year, matched only by the Great Financial Crisis in the last 20 years, and has been declining rapidly thanks to the Federal Reserve’s extraordinary interventions. And second, the difference between small-cap and large-cap volatility has remained near historic extremes even as volatility has declined for both size categories.

As shown in the bottom section of the chart, small-caps are almost always more volatile than large-caps (i.e., the volatility spread is usually above zero), with a historical average of about 4.5%. However, the latest readings on the volatility spread of over 14% are the highest in the last 20 years. That is, while large-cap volatility has dropped to a (still elevated) level of just under 24% (equal to average daily index movements of about 1.5%), the small-cap index volatility has only managed to decline to 38% so far (equal to average daily movements of about 2.4%). This is still far above the normal level of volatility for small-caps historically of about 22%.

The bottom line is quite straightforward: even after sharp rallies in equities and lower market volatility in general, owning small-caps remains much riskier on a price volatility basis than owning large-caps. So if expected returns must be commensurate with expected risk, then a decision to allocate heavily to small-caps requires either 1) an unusually high excess return expectation, or 2) an expectation of drastically lower small-cap volatility soon.

Given the economic backdrop and the reliance on government stimulus as well as the relative fundamentals of small-caps versus large-caps (a possible topic for another post), it may take a little while longer to have confidence that small-cap excess returns will be sufficient to compensate for their unusually high extra risk relative to large-caps.