Why Now Is the Time to Consider Strategic Small-Cap Allocations

Adding or increasing an allocation to small-cap equities could help institutional investors achieve a few common goals, such as potentially helping boost near-term performance or improving diversification. Allocating to small caps could also help offset the potential reduction in expected return for liability-aware investors who are increasing fixed income in their portfolios to reduce risk. 

There’s always a case for considering small caps, but right now may be a particularly compelling time to focus on the asset class. As the post-pandemic recovery continues, small caps are supported by economic dynamics and attractive relative valuations.

Small caps have historically performed well relative to their larger peers in the years following a recession. This is due to small caps’ more domestically oriented exposure and higher operational leverage, among other factors. Consider the dot-com bubble in the early 2000s. In the three-year period following that bear market, small caps¹ outperformed large caps² by 42%. A similar pattern played out following the 2008 global financial crisis (GFC). In the three-years following the GFC, small caps outperformed large caps by 32%.

While these past patterns don’t guarantee future performance, the 2020 pandemic-induced equity market drawdown isn’t unlike these two historical bear markets. Small caps today may be well positioned to turn in strong performance as economic recovery from the Covid pandemic continues. In fact, through the third quarter of this year, small-cap equities have outperformed their larger peers.

Small caps have lagged large caps since the spring of 2021, as market leadership has rotated away from cyclical, value-oriented areas toward more growth-oriented segments. This rotation has been prompted, in part, by concerns surrounding the economic recovery due to inflation and supply-chain challenges. Nonetheless, there is good reason to believe the cycle of small-cap outperformance is not over – rather, it may just be taking a breath.

For one, the prospects of an increase in infrastructure spending are likely to favor sectors more greatly represented among small caps, such as industrials, energy, and utilities. Further, companies today have amassed high levels of cash, which we feel will lead to, among other things, an increase in capital spending and M&A activity – both of which should favor smaller-cap stocks. As inflation and supply-chain issues work themselves out over time, helping to unleash further spending and investment, small caps are well positioned to potentially lead markets higher.

Favorable small-cap valuations

While economic dynamics support small caps, relative valuations for the asset class are also quite compelling. In fact, small caps are trading near their largest discount to large caps in 20 years. The small cap discount to large caps has grown over the past few years, in part due to the different sector compositions of the U.S. large- and small-cap indices.

For example, the S&P 500 Index has a significantly higher weight to the information technology (IT) sector, a growth segment that has outperformed over the past several years. On the other hand, the Russell 2000 Index has a higher weight in the financials sector, a more value-oriented sector that has performed relatively poorly. Notably, after small caps reached a similar level of “cheapness” in early 2001, shares of smaller-cap companies materially outperformed those of large caps over the subsequent three-, five- and 10-year periods.³

Modeling performed by abrdn suggests that moving a relatively modest 2% allocation away from other public equity into small cap could help improve both risk and reward metrics. In the view of abrdn, small-cap equity currently has an attractive expected return per unit of risk. In addition, small-cap stocks provide a diversification benefit since they are not perfectly correlated with other developed-market equities that typically have higher weightings within the portfolio.

Small cap and fixed income – an unlikely couple

Liability-aware investors who are at or near funded status might find particular utility in a small-cap allocation. It’s common for these investors, among others, to wish to reduce risk. A typical way to do this is to increase fixed-income exposure. But it’s also common to fear a reduction in the expected-return assumption as portfolios pivot toward greater fixed-income allocations. abrdn sees a combined, complementary allocation to both fixed income and small caps as a potential solution to this problem.

Increasing small-cap equity exposure alongside fixed income could help mitigate the negative impact on expected return that this low-risk fixed-income investment could have.

abrdn’s current, 10-year return expectation for small-cap equities is 11%, compared to 6.4% for large caps. The high return expectation for small caps could offset the drag fixed-income investments may have on the portfolio, potentially providing a very comfortable complement to a portfolio otherwise dominated by large caps. These two asset classes may make an unlikely pair, but they could potentially solve for the conundrum of reducing risk without reducing expected return.

¹  _{As represented by the Russell 2000 Index}

²  _{As represented by the S&P 500 Index}

³ _{At January 31, 2001, the forward P/E for the Russell 2000 relative to the Russell 1000 reached a trough of 0.73. Over the subsequent 3-, 5-, and 10-year periods, the Russell 2000 returned 19.0% (vs. -13.1% for S&P 500), 53.8% (vs. 1.9% for S&P 500) and 75.2% (vs. 13.8% for S&P 500). Source: FactSet}