Enhancing our active equity portfolios: Bye bye small cap stocks, hello momentum stocks

Starting April 1st of this year, we replaced US small cap stock exposure in our active equities portfolios with US momentum stock exposure. We did this because small, fast-growing, vibrant companies are choosing to stay privately owned rather than publicly listing their shares. In addition, internet business models have created a “winner-take-all” dynamic in many segments of the economy. As a result, we believe momentum stock exposure is better than small company stock exposure for capturing returns during periods of low stock market stress. More details below.


Exploiting equity factors to capture maximum risk-adjusted returns for our clients is a core element of our investment approach.  You can read more here on how we use factors in our portfolios.

We originally designed our active equity portfolios to seek small cap US equity exposure via the Russell 2000 index ETF (IWM) in times of low equity market stress, as determined by our equity market stress indicator.

The relative outperformance of smaller companies over many decades has been heavily studied in the investing industry literature, and it has been generally attributed to small companies’ better growth opportunities combined with their comparative obscurity. If fewer investors have researched these companies, the rationale goes, there is better opportunity for a smart investor to buy their shares at a good price before other investors catch on.

Over the past few years, the strength of the small cap factor has been shown to be weakening - this Research Affiliates study and this Wall Street Journal article both give a nice overview.

Moreover, the U.S. equity market has changed dramatically in the past decade, and one of the biggest changes has been the shrinking population of publicly-traded small-cap companies - read more on that in this Vanguard research note. There are still plenty of small companies, they’re just not going public anymore to fund their growth - read more on that here. Instead, they’re choosing to stay privately held because they’re finding it easier to raise financing in the ever-expanding private capital market, as described in this McKinsey report. For an excellent first-hand account of this phenomenon, read “Why so few of our companies aspire to go public” by SSM Partners, a growth private equity firm focused on smaller companies.

In addition, the winner-take-all dynamic driven by companies like Amazon, Google, Netflix, and other internet-centric businesses, described in this New Yorker article, means that growth is accruing to fewer and fewer of the remaining publicly-traded companies. This dynamic favors ‘momentum’ companies – those whose recent stock price performance has been better than average.

The above chart shows how big the performance difference has been between small cap stocks and momentum stocks. In the past 5 years, the MSCI momentum stock index ETF (MTUM) has delivered nearly 2x the return of the broad S&P 500 index ETF, and nearly 3x the return of the Russell 2000 small cap index ETF.

Momentum companies’ outperformance relative to the broader population of publicly traded companies isn’t a new phenomenon. MSCI publishes the US momentum stock index that our portfolios use via the MTUM ETF, and their research shows this to have been true for decades. But momentum’s outperformance relative to small caps is stronger than ever, and we believe this will persist into the future.

Derivative market stress abated in first 5 months of 2019, driving gains for short volatility investors

Back in 2018, US market equity market volatility caused our derivative market stress indicator to signal bearish positioning for 61% of the year. For a quick reminder of what was behind 2018’s volatility, take a look at this post. This means that our dynamic derivatives clients’ assets spent most of 2018 in cash or 10-year US treasuries, waiting patiently and safely for better opportunities to emerge.

The first 5 months of 2019 has shaped up to be a time of better opportunities. As the recession scare of Q4 2018 wore off, subdued volatility in equity and derivative markets has driven our derivative market stress indicator to signal bullish positioning for 66% of this year, through the month of May. The difference in short volatility conditions, and in the positioning of our indicator, is evident in the chart below.

*Past performance is not necessarily indicative of future results

*Past performance is not necessarily indicative of future results

Early May saw a surprising return of volatility - surprising because after months of headlines signaling positive developments in international trade negotiations with China, over the May 4th-5th weekend the US announced that the tariffs against Chinese imports would be levied after all, and that negotiations were headed nowhere. Our derivatives market stress indicator quickly turned bearish, and as a result our dynamic derivatives clients spent the rest of May in cash or US treasuries (depending on the strategy).

Government stimulus drove almost all of past 10 years’ S&P 500 gains

You’ve probably seen a chart like this one, showing the striking relationship of the S&P 500’s gains in the past decade to Federal Reserve stimulus phases 1, 2, and 3, known as ‘quantitative easing.’ But perhaps you’ve wondered if that relationship is just a coincidence.

Well, the fourth quarter of 2018 made clear it’s no coincidence.

S&P 500 and Fed Bal Sheet over time.png

We’ve marked periods on the above chart as easing, pause, and tightening, corresponding to whether the Federal Reserve was putting money into the economy, standing pat, or taking money out. Note we’ve also marked the ‘Tax Stimulus’ period, in which government economic stimulus was being applied, but not by the Fed.

Then we graphed these periods by average S&P 500 weekly return in each period vs. the amount of money each week the Fed injected into (or took out of) the economy in that same period, and ran a regression.

S&P 500 vs Fed Stimulus.png

What’s clear is that Federal Reserve stimulus drove most of the S&P 500’s gains over the past 10 years, and tax cut stimulus drove the rest. With an R-squared of 93%, data scientists call this sort of relationship a slam dunk. Rarely is such correlation between cause and effect found in the real world.

Now that the Federal Reserve is unwinding its balance sheet and is reluctant to lower interest rates, what does this mean? Sustainable gains in equities are becoming more elusive, and protecting against volatility will be critical.

Derivative market stress indicator protects our dynamic derivatives clients from much of 4th quarter 2018 volatility

The short volatility asset class generally experiences its best returns when the outlook for US stocks is improving or static, as occurred in 2017 with a rebound in GDP growth and the passage of the Trump federal tax break (click here to read more about that in a previous post).  

It generally experiences its worst returns when the outlook for US stocks is deteriorating, as occurred in Q1 2018 with trade war talk coinciding with the arrival of a new hawkish Federal Reserve chairman, worrying investors that inflation and tight money might all be coming quickly (click here to read more about that in a previous post).

It happened again more severely in the 4th quarter of 2018. While headlines were focusing on investor fears of recession, we think the real driver of stock market volatility was the unwinding of the Federal Reserve's balance sheet (click here to see the analysis we later shared on this point).

The chart below shows how our derivative market stress indicator helped our dynamic derivatives portfolios avoid most of the 4th quarter’s volatility. Our Titan strategy avoided more than 2/3 of the short volatility index’s decline.

*Past performance is not necessarily indicative of future results

*Past performance is not necessarily indicative of future results