Re-Thinking Volatility in Small Cap
Shifting Perspectives
When many investors think about U.S. small cap growth stocks, volatility often comes to mind. Over the past decade in particular, to say this volatility has not consistently translated into strong performance would be an understatement.
The opportunity is not about investing in small cap growth as a broad asset class, but in the underlying companies and innovations that define it.
This requires a mindset shift. We believe U.S. small cap growth is the bleeding edge of innovation, which in turn creates significant dispersion between winners and losers. The resulting volatility is not a flaw, but rather a byproduct of this dynamism as these emerging companies scale and find their product-market fit.
To an extent not seen anywhere else, this has historically created significant dispersion in the opportunity set. In this paper, we show how a volatile asset class with historically poor risk-adjusted returns can present a differentiated opportunity set for skilled managers. More importantly, we aim to show that many of the best managers in the asset class have processes to harness volatility to their advantage, enabling them to generate attractive risk adjusted returns.
The “Asset Class” Perspective
It seems small caps have generally suffered from a reputation of being highly volatile, with none of the returns to show for it. Over the past decade, a quick comparison of U.S. small cap growth against its large cap counterpart reveals -700bps of annualized underperformance with 20% greater volatility1. Why is this? By their nature, many of these small cap businesses are earlier in their life cycles, less proven, and in some cases, still trying to find their product-market fit. Growth is usually not linear. Many companies are not profitable and dependent on external financing. More constrained liquidity can amplify price reactions to the upside and the downside. All the while, along this journey investors struggle to assign the appropriate valuation for businesses at the vanguard of new markets that can go from disruptors to disrupted in a very short period of time. Biotech—the largest standalone industry in the Russell 2000 Growth—is a great illustration of this “boom-bust” dynamic.
The issue here is that when you think of U.S. small cap growth as an asset class, you accept everything—the good with the bad. And when you think about the dynamics of the asset class, it doesn’t have the same concentration and quality features of large cap, meaning overall asset class returns reflect the experience of the average company—unprofitable (or marginally profitable), economically sensitive, unproven business model, and no imminent competitive advantage. Confronted with these realities, one could be easily forgiven for deciding to forego an allocation or take a more tactical approach that uses the asset class as a vehicle to add risk based on interest rate and economic growth cycles.
As we’ll see in the next section, there may be a better way to approach investing in U.S. small cap growth. In our view, the asset class only perspective can obscure important differences within the opportunity set, and at worst, can lead to an “in or out” mindset using the asset class as a vehicle to tactically increase/decrease risk.
It’s not about the asset class writ large, but rather the opportunity set beneath the surface.
Download the full paper to discover why looking beyond asset class returns may lead to a different perspective on U.S. small cap growth.
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Index Definitions:
MSCI ACWI ex-US Index is a market capitalization-weighted index designed to measure the performance of large-, mid-, and small-cap companies across developed and emerging markets countries, excluding the United States. S&P 500 Index is a market capitalization-weighted index of 500 leading U.S. publicly traded companies designed to measure the performance of the large-cap U.S. equity market. Russell 1000 Value Index is a market capitalization-weighted index measuring the performance of large-cap U.S. companies with lower price-to-book ratios and lower expected growth characteristics. Russell 3000 Index is a market capitalization-weighted index representing approximately 98% of the investable U.S. equity market, including large-, mid-, and small-cap companies. MSCI ACWI ex-US Small Cap Index is a market capitalization-weighted index measuring the performance of small-cap companies across developed and emerging markets countries, excluding the United States. MSCI Emerging Markets Index is a market capitalization-weighted index designed to measure the performance of large-, mid-, and small-cap companies across emerging market countries. Russell 1000 Growth Index is a market capitalization-weighted index measuring the performance of large-cap U.S. companies with higher price-to-book ratios and higher forecasted growth characteristics. Russell Midcap Index is a market capitalization-weighted index measuring the performance of the mid-cap segment of the U.S. equity market. Russell Midcap Value Index is a market capitalization-weighted index measuring the performance of mid-cap U.S. companies with lower price-to-book ratios and lower expected growth characteristics. Russell Midcap Growth Index is a market capitalization-weighted index measuring the performance of mid-cap U.S. companies with higher price-to-book ratios and higher forecasted growth characteristics. Russell 2000 Index is a market capitalization-weighted index measuring the performance of approximately 2,000 small-cap U.S. companies. Russell 2000 Growth Index is a market capitalization-weighted index measuring the performance of small-cap U.S. companies with higher price-to-book ratios and higher forecasted growth characteristics. Russell 2000 Value Index is a market capitalization-weighted index measuring the performance of small-cap U.S. companies with lower price-to-book ratios and lower expected growth characteristics. It is impossible to invest directly in an index. The performance of an index does not reflect any transaction costs, management fees, or taxes.
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