The uneven post-pandemic rally has led to elevated concentration in large cap indices. The rally has reached the point where investors may question if equity markets can rise further amid tapering and yield expansion. In this environment, small cap equities can offer a solution.
We believe that the current combination of economic recovery and tightening but still easy monetary policy could allow investors to extract value through small cap strategies that, when compared to their larger counterparts, are more cyclical, more domestic and potentially less sensitive to moderate yield expansion.
Small Cap indices not only offer cyclicality but they also vary significantly around the world given the underlying differences across economies. Value-weighted exposures allow for an even greater level of cyclicality.
We explore these themes in our latest article where we analyse the case for small cap exposure in different geographies.
Small Cap Exposure: Implementation Ideas
Below we provide an overview of the different options investors have for gaining small cap exposure. Click through the ETF links to learn more about each fund, including full performance histories.
US Small Caps
The Russell 2000 Index allows investors to play cyclical recovery through higher exposure toward industrials and financials sectors relative to the S&P 500. Within financials, US small caps are naturally more oriented toward domestic, regional banks rather than global players. Heavy exposure to biotech affords investors a degree of structural growth as health care will likely remain in the spotlight even in the post-COVID world. The MSCI USA Small Cap Value Weighted Index is similar but with less health care and a higher cyclical and value tilt as financials represent more than a quarter of the overall exposure.
Europe Small Caps
Broadly, European equities are supported by undemanding valuations, appealing spreads to local bonds and relatively solid COVID management across the continent. MSCI Europe Small Cap Index and MSCI Europe Small Cap Value Weighted Index each have heavy exposure to the industrials sector, which could prosper from the next leg of the recovery, namely investment. Financial companies may benefit from yield expansion and are a significant component of these indices, while real estate has significant room to catch up with the broader market if the reopening continues.
World Small Caps
The MSCI World Small Cap Index allows investors to gain global cyclical exposure, combining the specific merits of smaller companies across the US (59% of the index) and Europe (21%). However, there is more to the exposure as the global index provides access to Japan (11%), which is itself a cyclical, export-oriented economy. In addition, Canada and Australia (3.4% and 3.3%, respectively) provide access to economies that are benefitting from high commodity prices.1
Emerging Market Small Caps
Emerging market (EM) small caps were one of a few parts EM universe that actually performed in line with developed markets. The reason behind this performance lies in the composition of the MSCI EM Small Cap Index. China represents only 8.7% of the index while it is 34% for a broader MSCI EM Index.2 Instead, Taiwan, India and South Korea make up 59% of the strategy. This exposure allows investors to enjoy growth from developing economies while at the same time mitigating some of the regulatory risk associated with China.
1,2Source: FactSet, State Street Global Advisors, as of 30 September 2021.
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