On its own, size is one of the most widely followed investment factors and one used to illustrate the historical out-performance of stocks with smaller market values over large-cap equities. While small size is its own factor, hundreds of active and passive funds marry small-cap stocks with another factor, usually growth or value.
“The payoff to most investment factors has historically been the greatest among the smallest stocks. This may be because they are more likely to be mispriced than larger stocks,” said Morningstar. “So—all else equal—funds that start with a universe of large- and mid-cap stocks (as most multifactor funds do) likely have less potential to outperform than those that start with an all-cap universe or a group of small-cap stocks.”
Speaking of multi-factor funds, the proliferation of such funds across the exchange traded funds (ETFs) landscape encompasses small-cap stocks. The JPMorgan Diversified Return U.S. Small Cap Equity ETF (JPSE) brings multi-factor investing to small caps, utilizing the value, quality and momentum factors in its security selection process.
A multi-factor approach to small caps can potentially limit some of the risks associated with single factor. For example, small-cap growth can be a particularly potent combination, but it can also expose investors to elevated volatility and larger drawdowns in bear markets. Small-cap value historically produces enviable long-term returns, but some studies suggest that there are periods in which the cheapest small caps (based on price-to-book) underperform. An index of small-cap stocks focusing on the low volatility factor may serve the end of reducing volatility but lack the ability meet an investor’s upside capture requirements.
Although many of the funds are fairly new, real world applications of multi-factor small-cap ETFs show promise. Since inception in mid-November 2016, the JPMorgan Diversified Return U.S. Small Cap Equity ETF has easily outpaced competing small-cap low volatility and value strategies.
There are limitations associated with single factor strategies, including sector biases, liquidity and market capitalization ranges. Obviously, a small-cap fund is constrained at the market cap level because, in a perfect world, small-cap funds’ holdings should have average market values of around $2 billion or less. JPSE’s largest holding has a market cap of $1.08 billion as of Sept. 17, 2018.
In addition to screening for value, momentum and quality, JPSE components are also weighted in such a way as to reduce single stock risk, a strategy that has historically helped drive strong performance. JPSE’s underlying index diversifies risk away from market segments lacking favorable traits while overweighting areas with better potential to deliver for investors.
Eliminating or reducing sector biases can be pivotal for long-term outcomes.
“Sector bias can be a source of uncompensated active risk that often isn’t necessary to capture the targeted factor,” said Morningstar.
Among the “big five” investment factors – low volatility, momentum, quality, size and value – quality is arguably the most overlooked. That is particularly true with smaller stocks where some investors accept lack of profitability, low return on equity (ROE) and other unattractive traits in the name of accessing growth.
While definitions of the quality factor vary, standard hallmarks include strong balance sheets, low debt levels, sound management teams and, in many cases, commitment to shareholder rewards via buybacks or dividends. In other words, the quality factor can be useful in identifying strong small caps.
Data suggest JPSE’s implementation of the quality is efficacious. Over the past year, the fund performed inline with the Russell 2000 Index, which has no quality screen, while outperforming the large-cap MSCI USA Sector Neutral Quality Index.
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