Over the past decade, the S&P SmallCap 600 has returned 8.2% annually, while the S&P 500 has returned nearly 13% annually.
Once a reliable growth engine, small-cap stocks have struggled for years. Fortunately, there are some portfolio tweaks that may help you beat the downturn and reap the outsized returns that small-cap stocks have historically provided.
This has been one of the worst periods in living memory for small-cap stocks. Over the past decade, the S&P SmallCap 600 has returned 8.2% annually, while the S&P 500 has returned nearly 13%.
The problem isn’t just the price of stocks. Today, only about 60% of small-cap stocks in the Russell 2000 are profitable, down from 70% before the pandemic. That’s one of the lowest levels since the 2008-2009 financial crisis.
Small-cap stocks typically make up only a small portion of investors’ U.S. stock holdings: 5% to 10% if weighted by market value, as index funds do. But they have historically been the engine of outsized returns, thanks to what academic research calls the “size factor.”
Investment writer Larry Swedroe recently wrote that if you go back to 1927, small-cap stocks have averaged an 11.7% annual return. That’s about 1.6 percentage points higher than the return on large-cap stocks. As a result, “the size effect is baked into the new workhorse asset pricing model of the financial industry,” which sophisticated investors use to evaluate potential deployments of capital.
No one knows for sure why so many small companies are struggling. One theory is that years of near-zero interest rates have left too many ailing companies languishing. Another is that many attractive, fast-growing companies are choosing to stay private, partly because of cumbersome regulations.
What should investors do? One solution is to shift portfolios toward smaller companies with strong profitability, trying to recreate the small-cap market of the past.
The S&P Small Cap Quality Index returned 9.8% annually over the past decade, beating the broad index by 1.6 percentage points. It nearly matched the S&P 500’s return until 2023, when the market’s mega-cap companies really took off.
Many exchange-traded funds target quality stocks, typically those with stable profits and strong balance sheets. The $41 billion iShares MSCI USA Quality Factor ETF is one, while the $8 billion Dimensional U.S. Small-Cap ETF is another.
Another strategy, Swedroe said, is to try to invest in smaller companies that are attractive to keep private. Private equity funds offer a solution.
Buying into these funds may require qualifying as an accredited investor, which means having a $200,000 salary or $1 million in investable assets. Traditionally, this has also meant high fees and long lock-up periods. However, Swedroe believes that new funds launched by fund managers such as Pantheon and JPMorgan Chase are trying to address these issues.
The article is forwarded from: Jinshi Data
