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Looking To Emphasize Quality With Small Caps

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Small-cap stocks are roaring back from the March lows. For example, the widely followed Russell 2000 Index is up more than 60% from its March nadir.

While growth prospects remain compelling with smaller stocks, evidence suggests there’s waning quality in the group, potentially exposing investors to undue risk. Some model portfolio, including the Core Equity Model Portfolio, which is part of WisdomTree’s Modern Alpha lineup of model portfolios, can help advisors steer clients toward higher quality small-cap fare.

“This model portfolio is designed for growth-oriented investors with a long-term horizon looking to maximize long-term potential for capital growth through a globally diversified set of equity ETFs,” according to WisdomTree.

Quality Matters

The size factor is one of the most durable themes in the factor space, but many investors often overlook the benefits of focusing on higher-quality small-cap equities.

“The intuition behind this anomaly is straightforward: Lower-quality small caps have less capacity to distribute earnings to shareholders or invest for growth, are more likely to issue shares and, in a worst-case scenario, are more likely to go bankrupt,” said Matt Wagner, WisdomTree senior research analyst, in a recent note.

An avenue to higher quality small-cap exposure is the WisdomTree U.S. SmallCap Dividend Growth Fund (NasdaqGM: DGRS), which is part of the Core Equity Model Portfolio.

DGRS tracks the WisdomTree U.S. SmallCap Dividend Growth Index, which is weighted by fundamental factors such as growth expectations, return on equity and return on assets, according to WisdomTree. The model portfolio’s weight to DGRS is compelling for multiple reasons.

“This long-run outperformance is compelling, but it doesn’t capture which market regimes are most conducive to small-quality outperformance,” notes Wagner. “According to Bank of America Research, high-quality small caps have outperformed low-quality small caps 100% of the time in late-cycle and recession phases over each observation since 1990. Small value, on the other hand, has had its most consistent outperformance in the early stages of an economic cycle.”

While the quality factor often trades at a premium to value, quality stocks are usually less volatile than traditional broad market strategies, indicating some overlap with the low volatility factor.

Valuing high quality value is particularly important as bull markets enter their waning stages, as some market observers believe the current bull market is doing. In the early stages of bull markets, lower quality companies see their shares soar.

For more on how to implement model portfolios, visit our Model Portfolio Channel.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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