Small-Cap Value Is Enjoying Quite the 2021 Honeymoon

Small-cap value has long been regarded as one of the most factor combinations and much of the enthusiasm for that marriage is derived from long-term returns.

With that in mind and acknowledging that 2021 is barely more than five months old, it's hard to ignore that small-cap value is off to a scintillating start this year. Though small-cap value isn't often measured against large-cap growth, advisors can regale clients with this fun fact: For the six months ending March 31, small value is beating large growth by the widest margin since 1943 – before the Allies stormed the beaches of Normandy – according to the Financial Times.

For advisors looking to capitalize on this trend within client portfolios, some familiar indexes paint an alluring picture. Let's start with the Russell 2000 Value Index, which is up 80.5% for the 12 months ending June 2.

Include that benchmark in a group with the Russell 2000, Russell 2000 Growth, Russell 1000 and Russell 1000 Growth indexes, and the benchmark that comes closest to value over the aforementioned is the Russell 2000 at 63.5%. The Russell 1000 Growth Index is up “just” 37.8% over that span.

More Points to Ponder

Of that group, the small-cap value index has the annualized volatility at 29.1% – somewhat surprising when considering small growth stocks are notoriously turbulent. However, the volatility gap between the indexes isn't alarmingly wide, meaning small value is delivering superior risk-adjusted.

Of course, much like the broader value space, this is a redemption story advisors are witnessing and it's one a long time in the making.

“Both small-cap stocks and value stocks have underperformed the broader market by extremely wide margins in recent years. From 2017 to September 2020, the Russell 2000 Value Index of small-cap stocks trailed the Russell 2000 Growth Index by 58% and underperformed large-cap growth stocks by more than double that,” according to Alliance Bernstein.

Additionally, now that we have the benefit of hindsight, it's clear what's powering the growth-to-value rotation: Cyclical stocks coming back into style and rising Treasury yields. The Russell 2000 Value Index is uniquely positioned to benefit from the latter scenario because it allocates 26.64% of its weight to financial services stocks and small banks were among the most damaged by years of low interest rates that pressured net interest margins.

Active Considerations

There's a fair chance that advisors reading this allocate to index funds tracking some or all of the aforementioned indexes. Makes sense because those products are usually fee friendly, which clients love. However, passive strategies in the small-cap factor universe aren't risk-free bets.

I bring that up for two reasons. First, as of June, the two largest components in the widely followed Russell 2000 Value Index are meme stocks GameStop (NYSE:GME) and AMC Entertainment (NYSE:AMC). Additionally, Caesars Entertainment (NASDAQ:CZR), a member of the large-cap S&P 500 for over two months now, is in the small value index despite it being neither cheap nor a small-cap name.

Second, Russell balancing is coming up later this month, meaning some of these hot stocks that are inflating the performance of the index are likely to depart. How that affects outcomes remains to be seen. Point is the small value resurgence might be opening some doors for active management.

“Value is an asset class, not an investment strategy,” notes Dimensional. “Identifying low relative price stocks is only one step toward designing and managing a value strategy; differences in managers’ implementation skill can lead to a wide range of outcomes experienced by value investors.”

Looked at differently, if advisors feel strongly about small-cap value continuing its bullishness, it's probably best to display that conviction with a vehicle dedicated to that trend and one free of meme stocks.

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