A More Informed Way for ETF Investors to Access Small-Caps

MarketsETF Trends

The macroeconomic and policy conditions support the case for investing in small-cap stocks. As investors look to smaller companies, consider the merits of a multi-factor or smart beta exchange traded fund approach to investing in this market segment.

While the small-cap segment has recently underperformed, investors may be in a position to capitalize on a turnaround as small-capitalization stocks have historically exhibited long-term outperformance relative to large-cap stocks.

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On the recent webcast, Small Caps and the Merits of Multifactor, Emily Roland, Head of Capital Markets Research for John Hancock Investments, outlined the underperformance of small-caps relative to large-caps in recent years, with an average -0.3% rolling 3-year excess return in the 2010s. Small-caps have been positive 43% in the 2010s.

Nevertheless, over the past 15- and 20-year periods, the Russell 2000 has outperformed the large-cap oriented Russell 1000.

“A regime shift may be in the cards,” Roland said.

Roland pointed out that over the last year, global macro dynamics may suggest a new so-called regime is developing where U.S. small-cap stocks may see a performance profile similar to prior similar environments. Specifically, Roland noted regime shifts triggered by improving global growth, tax cuts, normalizing monetary policy and deregulation or pro-business policies, all of which could support the small-cap segment.

As investors consider small-cap exposure, Joel Schneider, Senior Portfolio Manager and Vice President at Dimensional Fund Advisors, argued that one should also look into a smart beta or factor-based strategy that could potentially enhance returns and diminish potential downside risks.

“Efficiently capturing higher expected returns requires market participants to use the information contained in security prices rationally,” Schneider said.

Specifically, Schneider pointed to four factors that could help drive expected returns, including the equity premium or stocks over bonds; small-cap premium or small company stocks over large company stocks; value premium or value stocks over growth stocks; and profitability premium or stocks of highly profitable companies over stocks of less profitable companies.

“Academic research has shown that stocks characterized by smaller capitalizations, lower valuations, and higher profitability have delivered higher expected returns over time,” Schneider said.

As investors look for a small-cap ETF strategy that incorporates these potential enhancing effects, one may consider something like the John Hancock Multifactor Small Cap ETF (NYSEArca: JHSC). The underlying index is composed of small-cap stocks, excluding those companies with the highest valuations and lowest profitability

The underlying index will also follow a so-called index memory methodology where holdings may be expanded beyond the target range to minimize unnecessary trading and increased expenses. A momentum screen is also included where securities with low momentum do not receive increases to weights during reconstitution.

Financial advisors who are interested in learning more about the small-cap segment or multi-factor strategies can watch the webcast here on demand.

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