In recent years, many investors have focused on a restricted subset of the investment universe. Acronyms such as FAANG (Facebook, Amazon, Apple, Netflix and Google) and MAMAA (Meta, Amazon, Microsoft, Apple and Alphabet) and more recent references to the 'Magnificent Seven' and 'Sensational Six' have taken headlines and monopolised investors' attention.
This has some merit, as we have seen these names substantially outperform smaller peers. However, investing is centuries old and for some of this history, we have valuable data which illustrates that large-cap outperformance is not the norm.
Smaller stature, bigger returns
Over the long term, small-caps have typically outperformed large-caps due to their better growth prospects. Smaller companies are often quicker to implement new ideas and adapt to changing environments.
Additionally, they tend to carry more debt on average and are inherently riskier, which justifies their better performance as a reward for investors willing to accept this risk (positive 'size risk premia').
Nevertheless, large-caps frequently outperform for sustained periods and we have been experiencing such a period recently.
Lower interest rates tend to favour smaller companies, given their higher average debt levels. Conversely, large-caps, with lower debt burdens, are more resilient to high interest rates and typically perform better in such environments. As interest rates increase, large-caps tend to outperform and, conversely, as they decrease small-caps tend to do better.
Pending a pivot
Currently, investors are looking for a US Federal Reserve ‘dovish pivot’ to anticipate interest rates falling and act accordingly by tilting to small-caps. At the time of writing, the market expectation is for one or two cuts by the end of the year.
The European Central Bank recently cut interest rates, and the Bank of England is likely to follow, both ahead of the Fed, which is likely to benefit European small and mid-caps.
A positive size style environment (small-caps outperforming) provides more opportunities to benefit from a wider universe of outperforming stocks in line with the fundamental law of active management.
The information ratio increases with the breadth of independent investment ideas for a given level of skill.
Anecdotally, active managers find it easier to outperform index funds when small-caps outperform large-caps (or when equally weighted index portfolios outperform the indices themselves).
Alpha opportunity
If the pivot is delayed (‘higher for longer’), we expect to see the continued dominance of large-caps, value, quality and momentum styles.
However, the alternative regime of the positive size style environment is one that systematic equity market neutral strategies should prefer, given the increased breadth of alpha opportunities it offers.
The incoming environment change from large-cap outperformance to small-cap prominence will create further opportunities. This shift could stem from improvements in the economic environment for small-caps or from emphatic signals of interest rate reductions.
Dan Jelicic is chief investment officer of Trium Avala Strategies. The views expressed above should not be taken as investment advice.