The higher volatility in small-cap stocks deters many investors from adding them to their portfolio, but the impending tariffs and rising dollar means these stocks are a good tool for diversification.
Since small-cap stocks derive their earnings domestically, the profit margin of these companies are less affected by a strong or weak dollar and are “probably one of the best diversifiers for such exposure,” says Edison Byzyka, chief investment officer of Credent Wealth Management in Auburn, Indiana.
“Buyer beware — given that valuations in small-cap equities have risen substantially following the release of the new corporate tax rate and the notion of further trade protectionism,” he says. “As such rhetoric has expanded over the past 12 months, the flows and upside in small caps has been impressive, especially year-to-date when compared to broad large-cap indices.”
[See: 7 Small-Cap ETFs to Help You Win a Trade War.]
Large-cap stocks tend to be multinational companies who receive a large portion of their revenue globally, while small-cap companies sell most of their products within the U.S. where fluctuations in the dollar have less of an impact, says Michael Antonelli, managing director and institutional equity trader at Baird, a Milwaukee-based investment bank.
Since small-cap stock prices are more volatile, many investors cannot “stomach the swings,” he says.
“There’s also a higher chance of a small cap going to zero than a large, well established S&P 500 company, so that might scare people off, too,” Antonelli says.
Small-cap stocks can be more difficult to analyze and are more complex, says C.J. Brott, founder of Capital Ideas, a registered investment advisor in Dallas.
“The additional risk posed by the inability to finance a growing business without outside capital has been problematic during the last 10 years of credit tightness,” he says.
The difference in beta between the SPDR SPDR S&P 600 Small Cap ETF (ticker: SLY) and the SPDR S&P 500 ( SPY) is only 0.06, but the overall standard deviation is much higher.
“Higher returns justify the higher volatility, but most investors wrongly identify volatility with risk rather than opportunity,” Brott says.
Investors should allocate some portion of their portfolio to small caps since they represent excellent risk adjusted sources of additional return and the best strategy is to allocate money toward a low-cost mutual fund or ETF.
“This is especially true as the stronger dollar will favor those companies whose revenues are generated primarily domestically,” he says. “Add in the effect of tariffs on imported products and this should increase margins for domestic producers.”
While small caps can be a good part of a portfolio, they often have big moves, so investors should be prudent in their allocation, says Ron McCoy, CEO of Freedom Capital Advisors in Winter Garden, Florida.
“Unless you really know what you are doing, you might want to stick with an ETF like the Vanguard Russell 2000 ( VTWO),” he says. “You are seeing small caps do really well this year and a lot of it has to do with the U.S. economy doing so well.
[See: 7 Small-Cap Stocks with Big Dividends.]
Investors overwhelmingly focus on stocks listed in the major benchmarks, Byzyka says.
“The notion of the equity market, as deciphered by most investors is that of the S&P 500, the Dow Jones or the Nasdaq and pretty much nothing else,” he says. “The reality is that those three indices are simply a few of the available equity markets domestically.”
Even though indexes like the S&P 500 include 500 companies, it is market-cap weighted and the largest stocks in the index such as Apple ( AAPL), Microsoft Corp. ( MSFT), Facebook ( FB) and Berkshire Hathaway ( BRK.B) have the greatest sway, says Vahan Janjigian, a portfolio manager for Interactive Brokers Asset Management, a registered investment adviser based in Boston and chief investment officer of Greenwich Wealth Management.
The index can rise even if the majority if its stock decline “as long as a handful of very large stocks goes higher,” he says.
“When we’re in a bull market by the standards of this index, investors tend to focus on larger-cap names,” Janjigian says.
As more investors have shifted to passive strategies such as buying an ETF or mutual fund which tracks the index like the SPY ETF, the demand for the largest-cap stocks rises.
Investors are also prone to reacting to behavioral biases like loss aversion.
Since small-cap stocks are viewed as being more risky, when an investor buys one and it declines, he might feel as though a mistake was made.
“It’s his fault for going against the crowd,” he says. “If he buys a large-cap stock that falls, he may feel better about himself since he knows he has plenty of company.”
When investors consider diversifying their portfolios, they tend to focus too much on sectors. Instead, they need to consider that adding small caps gives them exposure to the U.S. economy, which remains strong, demonstrated by recent economic data, says Shawn Cruz, a senior trading specialist at TD Ameritrade, a brokerage company based in Omaha, Nebraska.
“When trade becomes a concern to investors, you see a lot of money flow into U.S.-based assets, since small caps are viewed as insulated from global risk,” he says.
[See: 7 of the Best Stocks to Buy for 2018.]
Small-cap stocks will likely face a headwind in the near term as the Federal Reserve is expected to raise interest rates several times, says Robert Johnson, principal at the Fed Policy Investment Research Group in Charlottesville, Virginia.
“I believe that the Fed will be even more resolute to raise rates in response to the tweets by President Donald Trump,” he says. “Federal Reserve Chairman Jerome Powell will want to assert the independence of the Fed and raise rates, contrary to the wishes of the president.”
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Small-Cap Stocks Add Diversification to Portfolios originally appeared on usnews.com
