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Opportunities in Small Caps: Consider Using a Multi-Factor Approach to Gain Exposure

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Opportunities in Small Caps: Consider Using a Multi-Factor Approach to Gain Exposure

As the market skitters across the top of a very long bull market and interest rates continue their slow and steady rise, investors who want to stick with equities face an important question: What steps can I take today to help improve the position of my client portfolios—regardless of when (not if) the market turns?

Attempting to time the market surely isn’t the solution. After all, it’s just as difficult to foresee when the market will begin to turn south as it is to know when a downturn has hit bottom and will begin to head skyward once again. The result: trying to time the market adds risk at both ends of the equation.

So what’s the solution if maintaining equities exposure is a priority? One option to consider is turning to small cap equities, using a multi-factor investing approach seeking to help improve overall portfolio efficiency. Not only does investing in small caps require no market timing at all, but small caps also offer these distinct advantages:

  • Small caps have historically outperformed large caps over extended cycles and exhibited similar drawdowns during market downturns.
  • They have a strong track record of recovering quickly from downturns; small caps bounced back more than twice as fast as large caps after the tech crash in the early 2000s, and 14 months faster than large caps following the credit crisis in 2008.1
  • Small caps tend to be more domestically oriented, making them less sensitive to global events and currency risk.2
  • Because they typically have less debt than large caps, in general, small caps are more insulated from rising interest rates.
  • Small caps have delivered positive returns and outperformed large caps in all eight rising-rate periods since 1994.
     

This consistent historical alignment with higher growth expectations compared to large caps in both market downturns and rising interest rate environments makes small caps a logical choice for suitable investors who want to stay invested in equities over the long term. That said, simply throwing cash at small caps using a market-cap weighted index may not be the most effective way to build up this asset class within a portfolio. Applying a multi-factor investing strategy has the potential to help manage equities risk and boost returns. In fact, in an internal research study looking at market returns of a multi-asset portfolio over the past 10 years, combining multiple strategic factors reduced risk by 20% and improved returns by 25%3. That’s quite a difference!

It’s no wonder factor investing has risen in popularity among advisors seeking alpha. Of course, factor investing is not a new concept by any stretch. William Sharpe was the first to identify the effect of single-factor investing back in the 1960s with his market-beta-focused Capital Asset Pricing Model (CAPM). In the early 1990s, Eugene Fama and Kenneth French took the theory further, introducing size and value as key characteristics for determining risk and return. (Remember that Fama, along with Lars Peter Hansen and Robert J. Shiller, was awarded the Nobel Prize in economics in 2013 for their “empirical analysis of asset prices”.) Then, in the late 1990s, Mark Carhart added yet another important factor, momentum, to the mix to create the four-factor model. Since then, quality and volatility have also become recognized as factors that influence and explain risk and return in a variety of market scenarios. Today, multi-factor investing is considered one of the most powerful tools for investors seeking to capture higher returns—regardless of current market conditions.

When looking at the advantages of small cap equities compared to large caps, and understanding the power of multi-factor investing, the logical next step is to bring the two together. Recent innovation has done just that, while offering all of the traditional benefits of an exchange-traded fund. For instance, the IQ Chaikin U.S. Small Cap ETF seeks investment results that track the price and yield performance of the NASDAQ Chaikin Power US Small Cap Index to provide exposure to domestic small-cap equities using a multi-factor model, The Chaikin Power Gauge.

Considering where we are in the market cycle today, some investors may not be as bullish about equities at the moment. But for those with longer time horizons, maintaining a healthy exposure to equities may be a wise choice. Small caps have historically outperformed large caps—especially in the face of rising interest rates and an equities market that is long past due for a downturn. Taking action before any shift occurs may be just the right move to help manage risk while still holding on to equities as a key component of your client portfolios.

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IndexIQ® is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC. Sal Bruno is a registered representative of NYLIFE Distributors LLC.
1Morningstar as of 5/1/17. U.S. Large Caps are represented by S&P 500 Index. The S&P 500 is an American stock market index, based on the market capitalization of 500 large companies having common stock listed on the NYSE or NASDAQ. U.S. Small Caps are represented by the Russell 2000 Index. The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index.
2 Morningstar as of 4/30/17.
3 Morningstar as of 3/31/17. Analysis conducted from 12/31/2004-12/31/2016. Optimum Factor Weights (Unconstrained) does not put a maximum weight on any particular factor when forming an optimized portfolio. Optimum Factor Weights (Max. 25%) applies a 25% maximum weight to any one factor when forming an optimized portfolio. Equal Factor Weights applies an equal weight to each factor when forming an optimized portfolio. The Market is represented by the S&P 500 Index. Standard deviation is a measure of the dispersion of a set of data from its mean.
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