Small Companies Outperform
Small Cap Effect – Small Companies Outperform
Thackray’s Seasonal Trade (Dec 19th to Mar 7th) Small Companies Outperform
Brooke Thackray, CFP, CIM, Research Analyst, Horizons ETFs Management (Canada) Inc.
The Small Cap Effect is an investment strategy that takes advantage of the tendency of small company stocks (small caps) to outperform large company stocks (large caps) from mid-December to the beginning of March. From December 19th to March 7th (1979/80 to 2014/15), the Russell 2000® Index (small cap stocks) has produced an average gain of 5.7%, compared with the Russell 1000® Index (large cap stocks) which has produced an average gain of 2.6%. In addition, small cap stocks have been positive 78% of the time and outperformed large cap stocks 69% of the time in the same period (Exhibit 1).
The Small Cap Effect is partly based on the January Effect, which is one of the better known seasonal investment anomalies. The January Effect postulates that stocks tend to perform well in January, rebounding, after suffering tax loss selling in December, with small caps performing particularly well.
Focusing on a small cap investment strategy only during the month of January has cost investors a lot of profits. Unfortunately, the January Effect does not capture the total benefit of small cap’s outperformance around the new year period. During the last half of December, small cap stocks tend to perform particularly well on an absolute basis and relative basis, compared with large caps. From 1979/80 to 2014/15, during the period of December 19th to December 31st, small caps have produced an average gain of 2.3%, have been positive 78% of the time and have outperformed large caps 69% of the time. In addition, during the period after January, from February 1st to March 7th, small caps have performed well on an absolute basis and outperformed large caps.
Exhibit 2 shows the average difference in performance between small caps and large caps from 1979/80 to 2014/15 during the period from December to March. It is interesting to note that both sectors of the market tend to bounce mid-December and then shortly after, small caps start to outperform. An overall positive market is particularly bullish for small caps at the end of the year.
One of the major drivers of small cap superior performance before the year-end and into the new year is based upon the behavior of money managers. At the beginning of the year, small cap stocks benefit from a phenomenon that I have coined, “beta out of the gate, and coast.” Money managers tend to take on more risk at the beginning of the year in order to get ahead of their benchmarks.
Moving down the company capitalization scale by investing in smaller companies is one of the preferred techniques. If money managers are successful and outperform their benchmarks, then they are in an ideal position to capture the gains by rotating from their overweight small cap positions back to index large cap positions and coast for the rest of the year with above average returns. On the other, if they are not successful, they at least have the rest of the year to make up ground.
Technically, small caps are currently just below resistance and their 200 day moving average (Exhibit 3). If small caps are able to break through resistance, look for the sector to reach its June highs within its strong seasonal period which starts in the second half of December.
In July 2015, small caps started a multi-month relative underperfor¬mance trend compared to the large caps (Exhibit 4). The previous underperformance may be acting like a compressed spring, setting up the small cap sector for a rally in its strong seasonal period starting later in December. Recently, starting in late November, small caps have been showing stronger relative performance compared with large caps. This is a positive indication for the upcoming seasonal period for small caps.
Horizons ETFs is a member of Mirae Asset Global Investments. The investment manager has a direct interest in the management and performance fees of the Horizons Seasonal Rotation ETF (the “ETF”), and may, at any given time, have a direct or indirect interest in the ETF or its holdings.
Comments, charts and opinions offered in this report are produced by www.alphamountain.com and are for information purposes only. They should not be considered as advice to purchase or to sell men¬tioned securities. Any information offered in this report is believed to be accurate, but is not guaranteed. Brooke Thackray is a Research Analyst with Horizons ETFs Management (Canada) Inc. (“Horizons”). All of the views expressed herein are the personal views of the author and are not necessarily the views of Horizons, although any of the investments found herein may be reflected in positions or transactions in the various client portfolios managed by Horizons. Horizons has a direct interest in the management and performance fees of the Horizons Seasonal Rotation ETF (the “ETF”), and may, at any given time, have a direct or indirect interest in the ETF or its holdings. Commissions, trailing commissions, management fees and expenses all may be associated with an investment in the ETF which is managed by AlphaPro Management Inc. The ETF is not guaranteed, its values change frequently and past performance may not be repeated. The ETF may have exposure to leveraged investment techniques that magnify gains and losses and which may result in greater volatility in value and could be subject to aggressive investment risk and price volatility risk. Such risks are described in the ETFs prospectus. The prospectus contains important detailed information about the ETF. Please read the prospectus before investing.