Only a handful of indexes existed 20 years ago. Today, there are substantially more indexes than publicly traded stocks, helping to drive demand for passive investments.
Despite the growing popularity of passive small-cap equity vehicles, we believe these strategies pose unique - and often misunderstood - risks to investors that are materially different from and significantly elevated relative to those inherent in the large-cap space. These risks are both structural and temporal in nature, and are heavily influenced by central bank monetary policy. Understanding these risks will be critical to navigating a shifting market environment.
Misperception #1: Risk in indexes is static.
Reality: Risk levels within the Russell 2000 fluctuate dramatically in cycles that can be tied to capital markets activity via IPOs.
Capital market cycles are tied to central bank easing cycles. Periods of low and/or falling interest rates - such as what we've seen for the last eight years or so - benefit long-duration cash flow streams. That's why riskier businesses that hope to be profitable in the long run, even if they're losing money today, will go public in periods of very low interest rates. IPOs are largely the provenance of small-cap companies, thus these activities have a significant impact on the composition of indexes such as the Russell 2000.
Because active managers typically consider a stock's quality within the portfolio construction process, they are, in our opinion, less inclined to embrace the riskier components of the small-cap index and thus tend to underperform the index during easing cycles. After the cycles have reversed, however, active managers have largely outperformed passive managers. For example, during the dot-com bubble, tech and telecom stocks rose to a 40% weighting in the Russell 2000, while the average active small-cap manager held at a maximum 20% weighting to these stocks. This hurt active managers during the bubble but benefited them when the bubble burst.
Active Managers Have Fallen Short as Bubbles Formed
Capital Market Cycle: Small-Cap Annual IPO and Secondary Proceeds
Source: Jeffries, Bloomberg, Morningstar. Data as of December 31, 2016. Note: Analysis was performed using all actively managed funds within Morningstar's Small Cap Blend Category. Funds that have merged or went out of existence were included in the analysis to minimize the potential for survivorship bias. *Total Period active performance includes only funds in existence for the entire time period. Graph represents IPO and secondary proceeds for companies less than $3 billion in market cap.
Misperception #2: All passive investing is created equal.
Reality: The Russell 2000 Index has roughly four times the exposure to money-losing companies versus the S&P 500.
An investment tracking the Russell 2000 would result in over one-third of an investor's money going into companies that are reporting losses versus just 10% for an investment tracking the S&P 500. The influence of the economic cycle is clearly evident across both indexes, with the number of money-losing companies increasing in periods of recession and decreasing following recessions. However, the percentage of loss-making companies within the Russell 2000 is structurally rising.
Over the long term, money-losing companies underperform profitable companies. During periods of central bank easing, such as 2013-2015, monetary stimulus has helped money-losing companies outperform, but history suggests this outperformance is not sustainable.
A Significant and Growing Amount of Companies Reporting Losses Comprise the Russell 2000
% Number of Loss-Making Companies in Index (Based on Trailing GAAP Earnings)
Source: Furey Research Partners, FactSet. Data as of December 31, 2016. Note: The % of loss-making companies is calculated by determining the number of benchmark holdings that have negative trailing GAAP earnings and dividing that total by the total number of names in the overall benchmark. This information is calculated for both the Russell 2000 and the S&P 500 on a quarterly basis.
Money-Losing Companies Underperform Profitable Companies Over The Long Term
Russell 2000 Total Return (Annualized)
Source: Furey Research Partners, FactSet. Data as of December 31, 2016.
Misperception #3: Index performance is driven by fundamentally strong companies.
Reality: Highly levered stocks have outperformed since the financial crisis.
Extended periods of extremely low interest rates benefit higher-risk balance sheets. Leveraged companies experience declining interest expense through short-term borrowing and/or refinancing long-term debt, while corporations with unlevered, cash-rich balance sheets experience declining interest income. Consequently, in the latest period of central bank policy easing, leadership within small-cap indexes has been skewed toward companies with business models predicated on high levels of debt rather than those with strong balance sheets.
With interest rates so low today, we believe the benefits of leverage likely have peaked. Underleveraged and, particularly, cash-rich balance sheets, however, could have untapped earnings power going forward.
Leveraged Business Models Outperformed in a Low-Rate Environment
Monthly Relative Performance of Highest Debt-to-Capital Companies (by Quintile) vs. Russell 2000 Index Excluding Financials
Source: Bloomberg; Russell Investment Group. Through December 31, 2016. Russell 2000 excluding any company classified as Financials under GICS classification.
Misperception #4: Small-cap companies have access to long-term financing.
Reality: The Russell 2000 is concentrated in shorter debt maturities, with an emphasis on leveraged loans and high yield bonds.
An investment grade rating is required to access 30-year credit, but only 9% of the weighting of the Russell 2000 Index is investment grade-rated, versus a 91% weighting within the S&P 500.
With a limited number of small-cap companies carrying an investment grade credit rating, most employ short-term floating loans, leveraged loans and/or high yield bonds for their debt financing. As the chart below shows, the Russell 2000 is concentrated in shorter debt maturities, while long-term financing is heavily skewed toward the S&P 500. While highly leveraged companies thrived in the very low interest rate environment of the past eight years, they find themselves exposed to rising interest rates as central bank policy normalizes.
Smaller Companies Have Not Locked In Financing Costs to the Extent of Large Caps
Debt Maturity Distribution of the S&P 500 Index versus the Russell 2000 Index
Source: Bloomberg, based on notional debt excluding financials. Information reflects all bonds outstanding regardless of maturity. Hedges are not included in this analysis.
Misperception #5: Interest rates can stay low forever.
Reality: Abnormally low interest rates create significant economic problems.
Policies that tamp down interest rates are not sustainable due to the significant economic problems they can cause.
In a persistent low interest rate environment:
- The creative destruction hallmark of capitalism doesn't work. Instead of more efficient businesses destroying weaker ones, all companies have access to capital on extremely easy terms. That leads to excess supply within the marketplace, lowering the pricing structure or returns available to deserving businesses in the process, and effectively depressing overall economic growth.
- Long term financial commitments - such as pension obligations, certain life insurance contracts, etc. - cannot be kept.
- Banks can't earn sufficient spreads to justify the risk of lending to the private sector and tend to prefer to lend to "lower-risk" government bonds (which they have been doing for some time), crowding out more efficient uses of capital.
- Savers tend to save more during periods of very low rates as interest and dividend income streams contract (look to spikes in home safe purchases in countries with negative interest rates for evidence), which in turn depresses overall demand.
That said, interest rates don't need to rise in order to stem the outperformance of leveraged business models; they just need to stop falling. The refinancing tailwind to leveraged companies likely is ending just as the headwind to unleveraged companies is ending. The company with no debt and net cash is earning close to zero on that cash - virtually any redeployment of cash will be, by definition, accretive to earnings, suggesting substantial untapped earnings power versus maxed-out earnings power for highly leveraged companies.
Given the fact that more than 90% of passive small-cap vehicles take a market-cap weighted approach to portfolio construction, money flows - and not business fundamentals - have been the primary driver of asset pricing in recent years. This is not capitalism, however, and we believe that ultimately the most deserving business models will again attract capital at the expense of the less deserving ones. We'd caution against trying to time this transition back to higher-quality investments. History - notably the dot-com mania of the late 1990s and the housing downturn more recently - has shown these shifts, often prompted by adjustments to monetary policy, can be abrupt and forceful. We have found that very few investors negotiate such changes well.
Misperception #6: Small-cap investing should be a tactical decision.
Reality: Active small-cap strategies have a strategic, long-term place in a diversified portfolio.
We believe the risks we've presented above are somewhat unique to passive small-cap strategies. Active small-cap managers that focus on higher-quality companies with balance sheet strength, free cash flow generation, high barriers to entry and above-average business models are not only well positioned if the market cycle shifts, but provide strong performance potential over the long run. Small-cap equities continue to receive less analyst coverage than their large-cap counterparts and continue to have inherent inefficiencies - inefficiencies that have increased due to passive investments driving the price up of potentially undeserving stocks - that active managers may be able to exploit.
Active Small-Cap Managers Have Outperformed the S&P 500 and Russell 2000 Despite the Recent Lag
20-year Total Return Through December 2016
Source: Morningstar. Information based on active managers currently categorized in Morningstar's Small Blend Category.
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