One of the trends in the aftermath of August’s short, sharp market dip is how quickly the UK’s small-cap indices bounced back. The late summer chaos left the FTSE 100 well down on where it started the year. By contrast, the FTSE SmallCap XIT is up by 10.5% in 2015 - and has clawed back much of the ground lost during the mayhem.
A lesson from this strong recovery by the small-caps is that all-cap diversification is a useful option when managing risk in a portfolio. In our previous coverage of portfolio management we’ve explored several ways of diversifying. That’s ranged from figuring out how many stocks it takes to meaningfully reduce risk to diversifying between factors like quality, value, momentum and low volatility. Arguably, diversifying by capitalisation is baked into all of those approaches. But we’ve never explicitly looked at the advantage of mixing large-caps with small-caps.
Different risk profiles
The case for including stocks of varying size has been made quite clear in recent months. Macro issues - ranging from uncertainty about growth in China to low oil prices - have dragged down the performance of blue chip shares. But smaller stocks have been much more resilient - a trend that Paul Scott picked up on here.
It’s an accepted truth that smaller companies often carry more risk for investors, partly because they’re less liquid and more susceptible to unforeseen problems. But on the upside, they are less affected by macro factors and more reliant on a growing domestic economy.
Jason Tannen, a portfolio manager at BNP Paribas, recently wrote that small caps should profit the most from an improving economic outlook because they have higher operating leverage to a domestic recovery than large caps, higher domestic revenue exposure and a higher exposure to cyclical sectors such as consumer discretionary. For those reasons, it’s no surprise that investors have been sanguine after the recent volatility - and quick to buy back in to smaller stocks.
But while small-caps have rebounded strongly from the recent market wobble, they aren’t always so strong. Back in 2008, when market values fell sharply, smaller stocks were panned. The FTSE SmallCap index slumped by 44%, while the FTSE 100 did rather better, falling by 28%.
These differing fortunes of large and small caps are usefully revealed in the following table (borrowed from…
