Valuing the Smaller Things
An asset allocation perspective on small‑ and mid‑cap value.
Key Insights
- While U.S. value and small‑ and mid‑cap stocks have been out of favor recently, we believe exposure to these styles can improve portfolio durability.
- Historically, small‑ and mid‑cap value have played important return‑enhancing and risk‑reducing portfolio roles, helping to reduce downside market exposure.
- History also suggests that investors who miss the initial months of a small-cap value outperformance cycle may sacrifice a large share of that outperformance.
The dynamic nature of capital markets means that generating durable investment results requires thoughtful portfolio design and ongoing revalidation of allocations through time. One key challenge is that markets evolve, and as a result, investment style leadership (such as the equity value style versus the growth style) tends to rotate over time. Historically, these cycles have lasted several years and have often prompted investors to question if an out‑of‑favor style will ever work again.
For most of the past decade, two equity styles—U.S. value and smaller capitalization (including both small‑ and mid‑cap stocks)—have been out of favor. However, while the shorter‑term performance of these styles has been challenged, longer‑term data (Figure 1) show that both approaches historically have been strong drivers of positive returns and have accounted for a meaningful portion of the broad U.S. equity market, equaling approximately 15% of the Russell 3000 Index as of March 31, 2020.1
Long‑Term Small‑ and Mid‑Cap Value Performance Tells One Story, More Recent Performance Another
(Fig. 1) Historical performance of equity style factors
Past performance is not a reliable indicator of future performance.
July 31, 1926, through February 29, 2020 (subset December 31, 2009, through February 29, 2020).
Source: Kenneth R. French (©2020). Used by permission. All data analysis by T. Rowe Price. The performance results and the size and style categories shown here are based on long‑term return series constructed by Dr. French using data from the Center for Research in Security Prices. Additional information on Dr. French’s return and factor methodologies can be found at his research site, on the Web at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/index.html.
The goal of this paper is not to validate the continued existence of any specific return premia for small‑ and mid‑cap value stocks. Rather, we focus here on the risk‑based case, hopefully demonstrating to investors the benefits of ensuring that their portfolio positioning is properly diversified through a thoughtful reexamination of their U.S. equity style and size exposures.
To help illustrate possible negative consequences of under‑diversification, we begin our analysis by reexamining the strategic allocation case for small‑ and mid‑cap value stocks, then take a closer look at some of the key attributes of these investment styles.
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1 The historical equity performance results and the size and style categories shown in Figures 1, 6, and 7 in this paper are based on long-term return series constructed by Dr. Kenneth French, a professor of finance at Dartmouth University, using data from the Center for Research in Security Prices. They are reproduced here by permission. Additional information on Dr. French’s return and factor methodologies can be found at his research site, on the Web at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/index.html.
Important Information — Hypothetical Portfolio
The information presented herein for the hypothetical portfolio is hypothetical in nature and is shown for illustrative, informational purposes only. It does not reflect the actual returns of any portfolio /strategy but rather a theoretical blend of the indicated benchmarks. The assumption of constant benchmark weights has been made for modelling purposes and is unlikely to be realized. The hypothetical portfolio does not reflect the impact that material economic, market or other factors may have on weighting decisions. If the weightings change, results would be different. Transaction costs, taxes, and other potential expenses, are not considered and would reduce returns. Actual results experienced by clients may vary significantly from the hypothetical illustrations shown. Data shown for the hypothetical portfolio is as of the dates shown and represents the manager’s analysis as of that date and is subject to change over time. The information is not intended as a recommendation to buy or sell any particular security, and there is no guarantee that results shown will be achieved.
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