Movers and SHAKERS
Small-Cap Stocks Have Been Performing at a Multiple of the Large-Cap Sector
In October, Channelchek published an article titled, “Which Stocks do Better After a Presidential Election?” The article looked back over 40 years and demonstrated that there has been a consistent outperformance of small cap stocks and explained some of the reasons smaller stocks could outperform large caps again.
It has been two months and we see that small cap stocks had a great month over the past 30 days. During the 30-day period ending December 10, the small cap Russell 2000 (RUT) index had gained 10.69%, compared to the S&P 500 (^SPX) increase of only 2.67%, and Dow Industrials (INDU) with a 2.05% increase.
This chart shows the Russell Small Cap Index(red) had a fivefold increase relative to the Dow 30 (yellow), and more than threefold compared with the S&P 500 Index (green).
Source: Channelchek Advanced Market Data
Based on these performance numbers, someone who invested for 30 days in a fund mimicking the RUT would have earned an additional 8% over the same investment in an ^SPX fund. If the same investor had placed money in an actively managed mutual fund designed to beat the small cap index, they likely would have been much more disappointed.
The small cap fund sector has been experiencing a lot of inflows during the last quarter of 2020. This is why it’s rising; this is how momentum builds. For the portfolio manager in an actively managed fund, this creates a few problems. The first is that the new money coming into the fund has to be invested or left in cash. During a fast upward moving market, cash detracts from performance. Alternatively, suppose the portfolio manager instead decides to invest the inflows. In that case, they will be investing at a time when stocks have already run-up, purchasing them at less than optimal times. They may be forced into decisions they would not have made with a more level and predictable account size. This sector had already had a good run up into November; an active fund manager putting money to work after the run-up is at a disadvantage versus the stocks represented in the index.
There’s another disadvantage a mutual fund portfolio manager, compared to an indexed ETF or even an individual investor may have as a rising market meets fund inflows. During the month of November, $5 billion in net new money was put to work in index-tracking, broad-based small-cap exchange-traded funds (ETF). This represented about 4% of the ETF’s total assets. Active managers usually don’t have as broad of a base of holdings instead as an index fund. More common is they take a higher percentage of their positions in the larger, more liquid names in the sector. When inflows to broad-based index funds accelerate, the smaller companies in the small cap universe often get lifted disproportionately, active funds participate less in these gains. On average, small cap actively managed funds returned about two percentage points less than the benchmarks during November.
Market participants have been expecting a strengthening in small and micro cap stocks for a couple of years. They had been underperforming and expected to revert to their mean average relative performance. The events of 2020 surrounding the pandemic drove a lot of investible cash to large tech companies leaving small cap stocks to have to wait a bit longer for their move.
The recent move in small stocks across the board remains strong. Profit-taking among the large cap sectors are fueling a rotation into the small sector as many still perceive it as undervalued. Investors also recognize that continued low materials prices should help many companies keep costs of operating below their pre-2020 levels while expectations of a post-COVID world should bolster profitability.