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The Evolution of Small Cap Investing

In nearly 40 years, small caps have gone from fad to a fundamental asset class.

The introduction of the Russell 2000 Index on Jan. 1, 1984, marked the first benchmark devoted to small cap stocks. At that time, small cap companies were seen as the Wild West, a large and mostly unsettled landscape where the usual conventions of investing did not necessarily apply.

Even three years later, the asset class was thought to be too volatile and unpredictable for long-term investors. It was largely ignored by newspapers of record as well, including The Wall Street Journal. “Small-stock investing had been a fad of big investors in recent years,” declared its popular Heard on the Street column on Dec. 7, 1987. “After three disappointing years of underperforming the bull market, small-company stocks were annihilated in the October crash. Now many small-stock money managers are wondering if their days are numbered.”

It would be almost another decade before the asset class gained widespread institutional acceptance.

In 1972, there were only 13 open-end small-cap funds offered in the United States. That number grew to 121 by 1992. Today, there are 501 small cap funds in addition to 113 exchange-traded funds.

How did popular perception shift from viewing small cap stocks as risky investments to seeing them as part of a well-rounded portfolio?

Dedicated Investing

Dedicated small cap investing started in the 1960s but gained traction in the 1970s, driven by the work of pioneering money managers who believed in the asset class. The creation of the Russell 2000 in 1984, with performance backdated to Dec. 31, 1978, was a critical step in the long march to small cap’s standing as an institutionally accepted asset class today.

At the end of 1985, nearly two years after its introduction, the weighted average market capitalization of the Russell 2000 was $129 million. In 1995, it was $446 million. As of November 30, 2022, that number stood at $2.927 billion – an increase of 1,990% since its introduction.

Moreover, there are substantial assets tracking the Russell 2000 and its variants (Russell 2000 Growth, Russell 2000 Value, etc.). Active assets under management benchmarked to the Russell 2000 were $1.4 trillion while passive AUM were $190.8 billion as of Dec. 31, 2019. There was also $65.9 billion in ETFs and $124.9 billion in other vehicles, such as index-linked swaps, insurance accounts, structured products and collective investment trusts, according to the index’s current owner, the FTSE Russell Group.

Distinct Differences

Part of the Russell 2000’s notable impact was not only the establishment of an unmanaged, capitalization-weighted index of small cap stocks but its usefulness in highlighting the differences between small- and large-caps, such as the wide disparity in analyst coverage and the potential for unexpected price swings.

In fact, by the 30th anniversary of the index’s founding, in a whitepaper titled “The Russell 2000 Index: 30 years of Small Cap” published on March 1, 2014, FTSE Russell wrote: “The potential long-term benefits of including small cap stocks as part of a diversified, global, multi-asset-class portfolio have been well documented by numerous academic researchers and industry practitioners. A wide body of research into what is now commonly called the ‘small cap risk premium’ has shown that small cap stocks have distinct risk/return characteristics that may provide diversification benefits and potentially enhance returns over time.”

One of the major differences is that analyst coverage of small cap companies continues to lag. The average number of analysts covering stocks in the Russell 2000 was 5.5 compared to an average of 15.3 analysts covering stocks in the large cap Russell 1000 Index as of Dec. 31, 2022. Moreover, 218 companies in the Russell 2000 (11% of the index) had zero or one analyst covering them compared to 13 companies (or 1%) with no analyst coverage in the Russell 1000.

Moreover, the stocks of small cap companies are generally viewed as having more volatile price swings due to their size. It takes less volume to move prices, which is why it’s not unusual for the price of a small cap stock to fluctuate 5% or more in a single trading day. It can distress investors who aren’t accustomed to that kind of movement.

These imbalances mean investors still disproportionately gravitate to domestic large cap companies. But those with patience and discipline can unearth potentially profitable long-term investments.

Outlook for Small Caps

As we approach the 40th anniversary of the Russell 2000, it’s important to remember the lessons learned from intense study of this asset class.

The near-term outlook is certainly cloudy, with most economists and even the U.S. Federal Reserve predicting a recession later this year. Before panicking, though, investors would do well to remember that a recession—like a bear market—is ultimately finite. Yes, it’s hard to maintain the resolve to stay invested when prices are falling. But, in most cases, each bear market has been followed by a recovery.

Since the end of World War II, most down years for small caps have been followed by positive performance. Prior to 2022, there were 24 years in which small caps had a negative calendar year return, according to the Center for Research in Security Prices. In 19 of the subsequent years—that is, 79% of the time—small caps enjoyed a positive return the following year.

Perhaps even more notable was that the average return for those positive years following a negative one was 25.9%—a substantially better result than the 10% average return for calendar years that followed a positive small cap return.

While it remains the most inefficient and labor-intensive segment of the U.S. equity market, it’s clear that the small cap ecosystem has evolved and matured into one that’s expected to benefit investors in the long run.

Francis Gannon is Co-Chief Investment Officer, Royce Investment Partners

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