The size factor is widely cited as one of the primary reasons why some smart beta strategies offer out-performance potential over traditional cap-weighted indexes. However, simply allocating larger portions of an equity portfolio to small-caps over large-caps is not always a winning strategy.
While smaller stocks may outperform their large counterparts over the long-term, small-caps are historically more volatile and there are no guarantees that smaller companies will deliver better risk-adjusted returns than large-caps. The good news is, when applied to smaller stocks, some investment factors can help enhance the returns of small-caps while potentially lowering volatility. Some exchange traded funds (ETFs) can help investors access a multi-factor approach to small-caps.
“Other factors, like value, momentum, and low volatility, have tended to work better among smaller stocks,” said Morningstar. “Deliberately targeting small-cap stocks with these characteristics will likely be more fruitful than a broad-based approach to investing in a broader cross section of smaller firms.”
The JPMorgan Diversified Return U.S. Small Cap Equity ETF (JPSE) is a multi-factor small-cap ETF idea to consider. JPSE, which is just over a year old, tracks the Russell 2000 Diversified Factor Index, a factor-based answer to the widely followed Russell 2000 Index.
That index uses “a rules-based approach that combines risk-based portfolio construction with multi-factor security selection, including value, quality and momentum factors,” according to JPMorgan Asset Management. “It Aims to diversify risk at the sector and stock levels while providing exposure to factors that have the potential to enhance returns.”
“Value stocks are thought to outperform either because they are riskier than their more-expensive counterparts and offer higher expected returns to compensate investors for that risk, or because they are mispriced,” according to Morningstar. “The risk-based explanation is plausible. Value stocks tend to have less-attractive business prospects than more richly valued stocks.”
Small-cap growth stocks, while potentially exciting, is usually among the more volatile smaller stocks. Conversely, small-cap value is historically one of the best factor combinations. By providing investors with exposure to the value and growth factors, JPSE ensures investors do not need to isolate those factors via individual stocks or funds.
The quality factor is also important as it pertains to smaller stocks. Many small-cap companies may offer compelling growth prospects, but that does not guarantee profitability or financial strength. By definition, a quality stock is likely to be backed by a sound balance sheet and a solid management team, traits that can reduce volatility, even with small-caps.
“Highly profitable stocks tend to be less volatile and hold up better during market downturns than their less-profitable counterparts,” said Morningstar.
JPSE is up 13.3% year-to-date, an advantage of 100 basis points over the Russell 2000 Index.