Throughout the credit-enhanced era, small-cap issues were one area where investors were well-advised to overweight in their portfolios. As history informs us, small-cap stocks outperform large caps due to their (on average) higher growth rates and (generally) greater risk. Greater risk equals greater rewards. Recently, however, circumstances have changed, and small caps look to bear the brunt of average performance, which means little to no alpha for portfolios seeking to beat the market.

Given the fact that the US economy is about to embark on a multi-year period of sub-par growth and greater government activism, the fact that small-cap companies tend to have a greater exposure to the US economy (and a lessened exposure to that area where growth will be greatest - emerging economies), it's no wonder the performance of this sector has, of late, begun to trail their larger-cap brethren; in particular, large-cap growth (IVW) - as the accompanying chart illustrates.


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Where small-cap growth (IJT) and value (IJS) were well ahead of the market last fall, they both have slumped to an average performance of late, while the more globally exposed large-cap growth (IVW) has moved to the head of the performance class.

There are several explanations for this.

First, as the following table shows, small-cap issues have an exposure to those economic sectors that aren't exactly high on the list of low-risk/good-growth prospects - such as Financials and Consumer Discretionary. Added to this, in the case of the small-cap value (IJS), is the overweight in the slow-growth Utilities sector. Then there's the underweight in an area that will benefit from the global-growth story in emerging economies: Energy.



On the plus side, small-cap growth (IJT) does have something of an offset with its above-average weighting in the globally exposed Info Tech and Industrials. Moreover, at this stage of the economic cycle, growth tends to outperform value. However, an offset is just that - an equalizer, and not a net positive.

On a larger and more important scale, US domestically exposed areas such as small caps are less likely to benefit from both the growth and capital flows to the strongest area of global growth: emerging economies. Moreover, emerging economies are less likely to be restricted by increased degree of regulation and oversight that US industries are experiencing as the Obama administration and the Democrats in charge tighten their grip on nearly all facets of commerce.

Investment Strategy Implications

For the most part, capital is loyal to no region or country. Investors and businesses are vested with one mandate: Earn the highest possible return commensurate with the appropriate degree of risk. As a result, investors are gravitating to where the investment prospects are best: regions and countries with higher growth rates, stable financial conditions, and a lessened regulatory climate. Viewed in this context, the developed economies (US and Europe, in particular) rank negatively compared to the emerging economies on all 3 levels.

The low-hanging investment fruit is to put more funds into emerging economies. This I've written about many times. The less-obvious area for consideration is an equal-to-below-average exposure in the former star of now-defunct credit-enhanced era:small caps.