An asset allocation perspective on small‑ and mid‑cap value.
- While U.S. value and small‑ and mid‑cap stocks have been out of favor recently, we believe exposure to these styles can improve portfolio durability.
- Historically, small‑ and mid‑cap value have played important return‑enhancing and risk‑reducing portfolio roles, helping to reduce downside market exposure.
- History also suggests that investors who miss the initial months of a small-cap value outperformance cycle may sacrifice a large share of that outperformance.
The dynamic nature of capital markets means that generating durable investment results requires thoughtful portfolio design and ongoing revalidation of allocations through time. One key challenge is that markets evolve, and as a result, investment style leadership (such as the equity value style versus the growth style) tends to rotate over time. Historically, these cycles have lasted several years and have often prompted investors to question if an out‑of‑favor style will ever work again.
For most of the past decade, two equity styles—U.S. value and smaller capitalization (including both small‑ and mid‑cap stocks)—have been out of favor. However, while the shorter‑term performance of these styles has been challenged, longer‑term data (Figure 1) show that both approaches historically have been strong drivers of positive returns and have accounted for a meaningful portion of the broad U.S. equity market, equaling approximately 15% of the Russell 3000 Index as of March 31, 2020.1
The goal of this paper is not to validate the continued existence of any specific return premia for small‑ and mid‑cap value stocks. Rather, we focus here on the risk‑based case, hopefully demonstrating to investors the benefits of ensuring that their portfolio positioning is properly diversified through a thoughtful reexamination of their U.S. equity style and size exposures.
To help illustrate possible negative consequences of under‑diversification, we begin our analysis by reexamining
Long‑Term Small‑ and Mid‑Cap Value Performance Tells One Story, More Recent Performance Another
(Fig. 1) Historical performance of equity style factors
Past performance is not a reliable indicator of future performance.
July 31, 1926, through February 29, 2020 (subset December 31, 2009, through February 29, 2020).
Source: Kenneth R. French (©2020). Used by permission. All data analysis by T. Rowe Price. The performance results and the size and style categories shown here are based on long‑term return series constructed by Dr. French using data from the Center for Research in Security Prices. Additional information on Dr. French’s return and factor methodologies can be found at his research site, on the Web at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/index.html.
the strategic allocation case for smalland mid‑cap value stocks, then take a closer look at some of the key attributes of these investment styles.
Our Portfolio Construction Principles
We believe that strategic asset allocation is the most important driver of outcomes over time for many multi‑asset portfolios and that equity allocations should be broadly diversified across regions, sectors, capitalizations, and styles in an effort to distribute and mitigate overall portfolio risk.2 Unless we have a particular investment objective, we tend to design strategic asset allocations that are styleand size‑neutral relative to broad market benchmarks like the Russell 3000 Index. There are two key reasons for this practice:
- Size: Market capitalization weights essentially represent investors’ consensus view of company valuations, and thus, in our view, are reasonable starting points in the absence of any particular view or objective.
- Style: Our process seeks to avoid undesired structural bias caused by elevated (or reduced) exposure to particular investment styles relative to the most commonly used core benchmarks.
We examined the potential risk of maintaining incomplete market exposure in a portfolio—specifically, strategic allocations that do not incorporate small‑ and mid‑cap value stocks. We looked at conditional value at risk (CVaR), a measure of downside risk, for four hypothetical portfolios that tracked different benchmarks or benchmark blends: the Russell Top 200 Growth Index (reflecting both a size and a style bias), the Russell Top 200 Index (a size bias), a blend of the Russell Top 200 and small‑ and mid‑cap growth indexes (both size and style biases) and the Russell 3000 Index (a balanced exposure).
Figure 2 shows the historical CVaR of each index over expanding rolling windows covering a period that began January 31, 1986, and ended March 31, 2020. Our analysis found that we could not have achieved the lowest historical downside exposure profile unless smalland mid‑cap value stocks were added to achieve a fully balanced portfolio (i.e., the Russell 3000 Index).
A Size‑ and Style‑Diversified Portfolio Historically Has Been More Defensive Over the Long Term
(Fig. 2) CVaR for rolling n‑month total returns
Past performance is not a reliable indicator of future performance.
January 31, 1986, through March 31, 2020.
Source: Russell (see Additional Disclosures). All data analysis by T. Rowe Price. The hypothetical index blend assumes monthly rebalancing and is not representative of an actual portfolio or investment.
The risk‑reduction potential of smalland mid‑cap value stocks may appear somewhat surprising given their cyclicality. However, as shown in Figure 3, investment substyles historically have diversified each other well during annual periods in which one of them has underperformed the Russell 3000 Index. To give just one example, Figure 3 shows that historically, when the Russell Top 200 Growth Index underperformed the Russell 3000 Index on an annual basis, the underperformance equaled about 6.4 percentage points, on average. By contrast, during those same periods, the Russell 2000 Value Index outperformed the Russell 3000 Index by 10.5 percentage points, on average.
Conditional Performance of Russell Style Indexes
(Fig. 3) Average 12‑month excess returns relative to the Russell 3000 Index
Past performance is not a reliable indicator of future performance.
January 31, 1986, through March 31, 2020.Source: Russell (see Additional Disclosures).
All data analysis by T. Rowe Price.
We believe that size and style diversification can improve portfolio durability across market cycles, as a properly specified portfolio should be less dependent on a single environment to succeed. In our view, a strategic allocation to small‑ and mid‑cap value equities can play an important role in achieving that durability.
1 The historical equity performance results and the size and style categories shown in Figures 1, 6, and 7 in this paper are based on long-term return series constructed by Dr. Kenneth French, a professor of finance at Dartmouth University, using data from the Center for Research in Security Prices. They are reproduced here by permission. Additional information on Dr. French’s return and factor methodologies can be found at his research site, on the Web at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/index.html.
2 Strategic allocation establishes the targeted mix of long-term asset class exposures.
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Important Information — Hypothetical Portfolio
The information presented herein for the hypothetical portfolio is hypothetical in nature and is shown for illustrative, informational purposes only. It does not reflect the actual returns of any portfolio /strategy but rather a theoretical blend of the indicated benchmarks. The assumption of constant benchmark weights has been made for modelling purposes and is unlikely to be realized. The hypothetical portfolio does not reflect the impact that material economic, market or other factors may have on weighting decisions. If the weightings change, results would be different. Transaction costs, taxes, and other potential expenses, are not considered and would reduce returns. Actual results experienced by clients may vary significantly from the hypothetical illustrations shown. Data shown for the hypothetical portfolio is as of the dates shown and represents the manager’s analysis as of that date and is subject to change over time. The information is not intended as a recommendation to buy or sell any particular security, and there is no guarantee that results shown will be achieved.
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