Advisors looking for exotic alternative asset classes to diversify their portfolios have an option right under their noses that may be more accessible and profitable than lumber or vintage wine: small-caps.
Yes, you read that right. While advisors immediately grasp the ease involved in small-cap investing, Eric Nelson of Servo Wealth Management makes the underappreciated case that small-caps function as a separate and countercyclical asset class.
In his latest blog post, the analytically inclined advisor seeks to demonstrate just how different small-cap stocks are from their large-cap brethren.
Investors, he says, tend to view small-caps as mere extensions of the large-cap market — “a riskier subset of a total stock index that will do relatively worse when stocks are declining and relatively better when stocks are appreciating.”
Nelson calls this notion “completely wrong,” a point he emphasizes through a comparison of large-cap and small-cap returns during four market cycles over the past three decades.
From 1982 to 1990, large-caps generated 16.3% annualized returns compared with 8.9% for small-caps — and this wide variance occurred despite the fact that the beta (a measure of sensitivity to market movements) for the Dimensional Fund Advisors US Micro Cap fund (DFSCX) was nearly perfectly correlated with the S&P 500.
Again we see a huge performance gap—this time in the opposite direction—from 1991 to 1994, where DFSCX earned 22.1% compared with just 11.9% per year for the S&P 500. This despite the fact that their betas were nearly the same (and indeed micro-caps’ beta was less than that of large-caps).
In the next period, from 1995 to 1999, small-caps generated annualized returns of 18.5%, but large-cap returns were in another league at 28.6% per year.
“A more volatile subset of the market would have been expected to earn 5% to 10% more than the market, but instead did -10% less,” writes Nelson, whose broader point is that the two market segments simply do not move in lockstep.