Growth or value in small caps? Consider a core approach

For diversified small-cap stock exposure, many U.S. equity investors take one of two paths: They either pair a value-oriented small-cap choice with a separate growth-oriented option or they select a single, style-blended core option. In this piece, we explore how a core approach to small caps can blend the attributes of both the value and growth styles without potentially subjecting an investor to the unintended sector concentrations that are common in small-cap indexes.

Growth or value in small caps? Consider a core approach

This question of paired style-specific approaches versus a core approach has persisted throughout my more than three decades investing in small caps, and it’s taken on new urgency in the wake of a small-cap rally that has been surprising both in its magnitude and in the changes that it’s produced for small-cap sector concentrations. The Russell 2000 Index posted a 31.37% total return in the fourth quarter of 2020—the strong performance extended into early 2021, with a January result of 5.03%.1 These impressive gains, however, didn’t come without some anxiety, from the turbulent U.S. political environment to headline-grabbing duels between short selling hedge funds and retail investor collectives that triggered extreme volatility in a handful of small caps.

Through such stretches of rapid change as well as periods of relative calm, our team has consistently maintained a core small-cap approach by investing in a diversified collection of quality businesses, regardless of style label. This flexible approach allows us to adjust equity style exposures as conditions change, as opposed to focusing exclusively on growth or value. 

Style box preference in small caps

An investor’s decision on how to allocate to small caps is often influenced by the size of the investor’s overall portfolio; larger portfolios tend to choose style-specific value and growth strategies for small-cap exposure, while smaller portfolios often default to core (blend) strategies. While this approach may be intuitive, there are certain pitfalls that we believe should be avoided.

First, by way of background, an analysis of the composition of value and growth benchmarks within small caps highlights significant sector concentration at the end of 2020 relative to the style-blended, core Russell 2000 Index. Healthcare and information technology are dominant sectors in the Russell 2000 Growth Index, with those two sectors alone accounting for just over half of the index’s overall composition across 11 sectors.2 In the Russell 2000 Value Index, financials and industrials are dominant.3

Small-cap core has less sector concentration than growth and value

Aggregate weight of top two sectors (Russell 2000 indexes) (%)

Small-cap core has less sector concentration than growth and value

Source: FactSet Research Systems, as of December 31, 2020.

This concentration intensifies when you drill down within sectors to the industry level, showing a growing influence of the top three industries over time in each of the three indexes.

Industry concentration has grown across small-cap indexes in recent decades

Aggregate weight of top three industry groups (Russell 2000 indexes) (%)

Industry concentration has grown across small-cap indexes in recent decades

Source: FactSet Research Systems, as of December 31, 2020.

One additional point regarding index construction is that sector and industry exposures have historically been more volatile in the respective Russell 2000 Growth and Russell 2000 Value indexes than in the core index, the Russell 2000 Index.

Industry concentration has historically been less volatile in small-cap core

Standard deviation of industry group weights (Russel 2000 indexes)

Source: Furey Research Partners, October 2020.

What does this mean for small-cap investors? When creating a value and growth combination, we believe that an investor must take significant care to try to control for factor, sector, and industry risks to the desired outcome. Understanding the nuances of a given approach to small caps may help an investor avoid unintended exposure in the pairing that exists due to the concentrated nature of the benchmarks the managers follow. For example, pairing a value manager who follows a more benchmark-centric strategy with a growth manager who leans more conservatively may result in an allocation that is underweight in key areas such as biotech, pharmaceuticals, and technology. Unintended risks may also arise when active growth and active value managers aren’t sufficiently complementary.

Using a core strategy may help to reduce the potential for unintended portfolio concentrations while also potentially benefiting from the manager’s flexibility to pursue a broader range of opportunities along the full value-growth style continuum. Additionally, choosing core allows investors to focus their risk budget on a smaller number of strategies without giving up the ability to seek alpha, again given the flexibility inherent in a core approach. 

An agile, well-resourced approach to small-cap investing

We believe that our core approach to small-cap investing helps us to navigate the value-growth continuum as market opportunities warrant, using a proven fundamental investment process. In our view, the flexibility that this approach affords is especially well suited to an uncertain market environment like the one we’re in today—one in which the pandemic continues to shift in character, introducing new variables for the economic recovery that’s helped to drive the recent small-cap rally.

 

 

1 FactSet, 2021. 2 FTSE Russell, Russell 2000 Growth Index fact sheet, as of December 31, 2020. 3 FTSE Russell, Russell 2000 Value Index fact sheet, as of December 31, 2020.