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SMid as a Substitute for Small Cap
Investors interested in gaining exposure to the small-capitalization growth equity style should consider the small/mid (“SMid”) capitalization style as a way to capture the benefits of small-cap growth. Research shows that the SMid growth space can offer diversification and low correlation to larger-cap equities with additional benefits gained from exposure to the lower cap range of the mid-cap growth space, which offers attractive performance and risk/return characteristics.
The following analysis uses the Russell 2500 Growth Index as a proxy for SMid-cap growth equities and the Russell 2000 Growth Index as a proxy for small-cap growth equities. The time period covered in this analysis is the entire 23¾-year history of the Russell 2500 Growth Index: January 1986 through September 2009.
Historical Performance
Historically, SMid-cap growth equities have outperformed small-cap growth on a quarterly, annual, cumulative, and rolling 1-, 3-, 5-, and 7-year basis.
SMid-cap growth outperformed small-cap growth in 60 of the 95 quarters covered in this period (63.16%). The average excess quarterly return was 1.45% when SMid-cap growth outperformed small-cap growth and -1.13% when SMid-cap growth underperformed small-cap growth.
SMid-cap growth outperformed small-cap growth in 16 of the 23 calendar years covered in this period (69.57%). The average excess annual return was 4.2% when SMid-cap growth outperformed small-cap growth and -1.82% when SMid-cap growth underperformed small-cap growth.
Over the entire 23¾-year period, SMid-cap growth outperformed small-cap growth by 212.24% on a cumulative basis and 2.22% on an average annualized basis.
For the trailing 5-, 7-, 10-, 15-, 20-, and 23¾-year periods, SMid-cap growth outperformed small-cap growth by more than 1.5% on an average annual basis
On a quarterly rolling 3-year basis, SMid-cap growth outperformed small-cap growth in 78 of the 84 periods (92.86%). The average annualized excess return for the three-year period was 2.36% when SMid-cap growth outperformed small-cap growth and -0.53% when SMid-cap growth underperformed small-cap growth. On both a rolling 5- and 7-year basis, SMid-cap growth outperformed small-cap growth 100% of the time. The average annualized excess return for SMid-cap growth was 2.18% on a 5-year basis and 2.19% on a 7-year basis.
The longest period that SMid-cap growth underperformed small-cap growth was the four consecutive quarters from Q2 2003 to Q1 2004. Only three other times in the 23¾-year period has SMid-cap growth underperformed for at least three consecutive quarters.
Risk
Performance is only one side of the story. In order for SMid-cap growth’s potential excess returns to be attractive to investors, performance must not come with an offsetting amount of risk. SMid-cap growth not only has lower historical risk (as measured by standard deviation) but also has shown consistently lower volatility. SMid-cap growth has had lower volatility than small-cap growth for 17 out of the 23 full calendar-year periods, or 73.91% of the time. On a trailing 3-, 5-, 7-year, and since inception basis, SMid-cap growth has also had lower volatility than small-cap growth (Figure 3).
For the trailing 1-, 10-, 15-, and 20-year periods, the annualized SMid-cap growth standard deviation exceeded that of small cap. However, the excess standard deviation of SMid-cap growth was less than 75 bps in all but one period, resulting in an average of only 45 bps of total excess standard deviation for those periods.
Bringing performance and volatility together, we next look at risk-adjusted performance to determine the relative attractiveness of the SMid-cap growth space. Over the trailing 5-, 7-, 10-, 15-, and 20-year periods, the annualized alpha of SMid-cap growth versus small-cap growth has been consistently positive (Table 1).
This suggests that the relative level of volatility, as defined by beta, is justified by the incremental performance gains achieved from the mid-cap growth exposure (Figure 4).
While SMid-cap growth exhibits higher volatility for some of the trailing periods discussed, the annualized alpha for all but the most recent period is still positive as a result of the substantial average annualized excess return of 222 bps.
The reason why we believe that the risk adjusted SMid returns have historically been higher than small cap is due to two things:
- Historically the mid-cap space has had lower volatility than small cap. As companies mature and grow in size their risk level, in the aggregate, decreases. The inclusion of larger more mature companies in the SMid universe has lowered the risk profile. This can be seen in the standard deviations of the Russell MidCap Growth and the Russell 2000 Growth indices.
- The companies in the sub-seven billion dollar market cap range of the Russell MidCap Growth index have outperformed the larger stocks in the index.
The combination of allowing small cap managers to hold on to their winners, proven companies in the midst of generating alpha, longer and the added risk reducing characteristics of those stocks has led to a consistent risk-adjusted advantage for the SMid-cap space relative to small cap that we believe will continue.
What makes a good substitute?
The cornerstone of asset allocation is diversification to minimize unsystematic risk, achieved through investing across asset classes that have less-than-perfect positive correlations. For this reason, when considering SMid-cap growth as a suitable alternative for small-cap growth, several correlations must be evaluated. For this analysis, we examined the relative correlation of SMid-cap growth and small-cap growth against broad domestic U.S. equity indices as well as each other (Table 2).
Both SMid-cap growth and small-cap growth have correlations that are between 0.84 and 0.90 relative to the Russell 1000 Growth, Russell 3000 Growth, and Russell 3000 over the 23¾-year period. The correlations drop even lower when compared to the S&P 500. Interestingly, while the SMid-cap growth correlations to the broad market are slightly higher than that of small cap, the correlation relative to small-cap growth is very high at 0.99 (almost perfectly positive; a bad diversifier but a great substitute).
The reason why the correlation is high and is expected to persist at that level, is the foundation of why SMid-cap growth can be viewed as an alternative to small-cap growth. As of September 30, 2009, there were 1,261 stocks in the Russell 2000 Growth Index. The Russell 2500 Growth Index consisted of those stocks as well as an additional 307 stocks. This overlap in holdings helps explain why there is such a high historical correlation between the two indices. Moreover, the fact that the SMid-cap growth space, by definition, includes the entire small-cap growth space explains why the observed correlation is expected to persist.
While the overlap explains the correlation and helps to validate the potential for substitution, the additional 307 stocks explain the expected benefit. Those additional stocks account for approximately 54.4% of the Russell 2500 Growth Index by weight, therefore representing a disproportionate percentage of the overall index performance (19% of the stocks accounted for 54% of the performance). The added diversification also helps to explain why the volatility of SMid-cap growth, which is generally expected to be higher than the volatility of mid-cap growth, has been historically lower than small-cap growth. It also explains why the historical performance of the two has been so different.
Move dollars from small to SMid?
As we have shown, SMid-cap growth has historically had higher performance than small-cap growth on both an absolute and risk-adjusted basis, while also exhibiting consistently lower volatility on both a rolling-period and annual basis.
However, in order for SMid-cap growth to be seen as a valid substitute for small-cap growth, it must not only offer the same diversification benefits as small cap but also must not increase the asset category’s correlation to the remaining portfolio. The historical correlation between small-cap growth and SMid-cap growth has been very high, nearly 1.0. The composition of the SMid-cap growth universe (which encompasses the entire small-cap growth universe) ensures that the diversification benefits of the small-cap growth space should not only be achieved in the SMid-cap growth space but should persist.
The historical evidence presented strongly supports the conclusion that SMid-cap growth, with its attractive combination of higher historical performance, lower historical volatility, and similar historical broad market correlations, should be seen as a compelling alternative to small-cap growth in your clients’ portfolios.
David Vincent is a Vice President and Senior Investment Analyst with Fred Alger & Company, a New York-based investment management firm.
The performance data quoted in this material represents past performance, which is not an indication or a guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted. For performance current to the most recent month end, visit www.alger.com or call (800) 992-3863.
The Russell 1000® Growth Index is an unmanaged index designed to measure the performance of the largest 1,000 companies in the Russell 3000® Index with higher price-to-book ratios and higher forecasted growth values. The Russell 3000® Growth Index is an unmanaged index designed to measure the performance of those Russell 3000 Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000® Growth Index is an unmanaged index designed to measure the performance of the 2,000 smallest companies in the Russell 3000 Index with higher price-to-book ratios and higher forecasted growth values. The Russell 2500™ Growth Index is an unmanaged index designed to measure the performance of the 2,500 smallest companies in the Russell 3000 Index with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on the total market capitalization, which represents 98% of the U.S. equity market. The S&P 500 is an unmanaged index generally representative of the U.S. stock market in general without regard to company size. Index returns do not reflect the deduction of fees, trading costs, or other expenses. The Index is referred to for informational purposes only and the composition of the Index is different from the composition of the accounts managed by Alger. There is no guarantee that the index returns will be comparable to any product managed by Alger. For information on Alger products, please contact your financial advisor. Investors cannot invest directly in any index.
The views expressed are the views of Fred Alger Management, Inc. as of September 2009. These views are subject to change at any time and do not guarantee the future performance of the markets, any security, or any funds managed by Fred Alger Management, Inc. These views are not meant to provide investment advice and should not be considered a recommendation to purchase or sell securities.
Calculations for all charts were performed by Alger using data from FactSet, a provider of financial information and analytic applications for investment professionals.
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Fred Alger & Company, Incorporated, Distributor. Member NYSE Euronext, SIPC.
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