Not All Small Caps Are Created Equal

For Professional, Accredited and Institutional Investors only.

Don Klotter - CEO EFGAM North America

When it comes to investing in U.S. equities, the conventional wisdom is clear. The U.S. equity market is efficient—especially among the larger companies in the universe. Therefore, one of the prudent ways to invest is to buy a benchmark-hugging passive index fund. Own shares in this index and ride the wave of the market as a whole.

But is this really the case?

As we have witnessed in the last year with the emergence of the so-called “Magnificent 7,” the market information on these companies is far from perfect despite their size, and likewise, there can be a large dispersion between the winners and the losers. Using the S&P 500 as a proxy for the overall market, most of the universe had relatively benign performance in 2023, with many stocks even recording negative returns. Yet the stellar performance of the chosen seven buoyed the overall returns so much so that it appeared like a banner year in equity investing.

Some would say that this concentration of returns is exactly why you own everything—to make sure you do not miss out on the big winners. Fear of missing out (FOMO) is a very strong motivator. The flip side of this argument, however, means you are also dragging along all the losers in your portfolio as well. And what happens when one of those giants stumbles, as stocks do not go up to infinity? As an index investor, you will continue to own all of the relevant index shares, regardless of fundamental performance and whether a stock is going up or down.

Perfect is the enemy of good.

I would argue that you do not have to get all of them right to have success. The benefit of getting most of the Magnificent 7 can well outweigh the cost of dragging along the remaining 493.

Consider my company’s story in 2023, where our U.S. large-cap growth portfolio achieved a 51.2% return, outshining the large-cap growth index by nearly 10% and the S&P 500 by 27% (2023 relative performance as of 12/31/2023). What makes this noteworthy is the intentional omission of some of the Magnificent 7 from the portfolio, specifically Microsoft. So, why would we stray away from the herd?

Let me start by saying that the Magnificent 7 has largely gone up because they are high-quality companies and are executing at a higher level than all their peers. They generally feature higher growth rates, higher margins and larger addressable markets. They are going up because they deserve to. The problem is that these winners have gotten so large that now there is a much more significant concentration risk, should any one of them have an issue. To provide diversification from this risk, we chose to substitute exposure in one of the stocks (Microsoft) with other, less dominant players that will still benefit from the same themes and tailwinds. And while we missed out on one of the best-performing stocks as a result, we also benefited from greater risk management and still had enough performance from our substitute choices to exceed the market return.

Active management is key amid market turbulence

Volatile times can create great opportunities for active managers. In fact, an active management strategy may be crucial when uncertainty is highest. With the current economic landscape, marked by inflation, high interest rates and geopolitical uncertainties, outcomes can vary by sector, industry and geography. Dispersion among winners and losers can be significant, and in such environments, owning every stock in the index may be negative. Diversification, flexibility and strategic adjustments are needed now more than ever, and active managers can navigate nuanced and shifting market dynamics.

With the adaptability to changing market conditions and freedom from the constraints of predefined indices, active managers can capitalize on emerging trends and proactively respond to economic shifts. Our deliberate exclusion of Microsoft from our growth portfolio showcases active management’s strategic decision-making, diverging from consensus and demonstrating the potential for outperformance by exploring “less popular” options.

A benefit of an actively managed portfolio is that investors can get exposure to other companies and industries that may be overlooked. So, where are the other untapped industries that investors should be looking at? In 2022, Big Tech (highlighted by the Magnificent 7) were some of the worst-performing companies in the market (as of 12/21/2022). In 2023, part of the healthcare sector, along with energy, was left for dead, so maybe 2024 could be their year to shine.

A different way of thinking is to focus only on the very best within each sector and avoid those who have made mistakes. In early 2022, when everybody was predicting a U.S. recession, nobody was betting on the U.S. consumer to remain resilient. Yet consumers continued spending, but in many cases changed spending patterns to only include companies and products they believed in and felt aligned with. This benefited the strong and authentic brands while punishing those viewed as out of sync or not aligned. Being selective as to where you invest can make a major impact in this scenario as well.

As we venture into the realm of investment opportunities beyond this heavily concentrated elite group of winners, the key takeaway is clear: A diversified approach and an active management strategy can offer market-beating returns even in the part of the market deemed most efficient. By exploring sectors overshadowed by bad news (financials?) and focusing on the highest quality performers within each sector, investors can best position themselves for potential successful returns. In our world today highlighted by speed of change, the allure of familiar names may be compelling, but the true gems may lie beyond the well-traveled path.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Past performance is not a guide to the future. Returns may increase or decrease as a result of currency fluctuations.

Originally published on Forbes.com - https://www.forbes.com/sites/forbesfinancecouncil/2024/04/23/what-lies-beyond-the-benchmark/

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