By Kyle Waller, Research Analyst Wiser Wealth Management, Inc & Casey T Smith, ASA ALPA 401k Specialist
In 401K investing, there is a major asset class that does not get the respect it deserves. In fact, it is largely ignored both by investors and plan sponsors. This asset class, small cap stock funds, is a very important element in a 401K plan.
Throughout the history of the stock market, small cap stock funds have significantly outperformed their larger counterparts. There are some reasons for this that make small cap funds a category that should not be overlooked in your plan. That being stated, the potential for excess long-term performance comes with some serious risks that should also not be overlooked because of downside risks and excess volatility.
The JPMorgan ASA employee 401K plan has three small cap funds. Two of those funds have a management strategy designed to invest in growth stocks, while one fund is designed to invest in value stocks. Below is the Morningstar Style box, which simply categorizes large, mid and small in rows, while placing the “styles,” (value, blend and growth) in columns. Style is something to consider when choosing funds, but size is more important to consider. Size tends to be a larger determinant of returns relative to style. However, most mutual funds have both size and style directives and both should be taken under consideration before choosing one.
Small Cap Stocks as Building Blocks
Building a solid portfolio can be done with many different strategies, but most professionals believe that having a diversified portfolio based on asset allocation is most appropriate. Asset allocation would mean that a portfolio would include diversified investments from different categories, and apply different weighting based on the investor’s individual risk tolerance and how risky each investment is. Most allocations are based on age or years to retirement.
The three small cap funds in the ASA employee 401K plan are the Buffalo Small Cap, Columbia Small Cap Value II Z and the LKCM Small Cap Equity Advisor. When reviewing these funds, it is important to study risk, cost and track record, among other factors. Cost takes away from return, and there are hidden costs to consider like turnover, which is the fund’s trading frequency. This is an important consideration, because these trades incur cost for the mutual fund. A random track record statistic alone should not be the deciding factor; it should be compared with benchmarks. For example, it would make sense to compare a small cap growth fund’s return with a small cap growth benchmark. There are several ways to look at a fund’s risk. One way is to simply look at its standard deviation, which is a measure of variability from the mean. The higher the standard deviation, the higher the risk is perceived to be. Often, standard deviation is just called risk, like you see in the scatter-plot below.
The Importance of Small
Below, we see the difference smaller companies can make. Over last 15 years, we see that small cap companies significantly outperformed the large cap S&P 500, despite underperformance during the tech bubble. Going back further would reveal that this pattern does exist over long periods of time.
So, what is the cause of this higher performance? Put simply, smaller companies tend to grow at a faster rate and, over time, larger companies still grow, but much more slowly. Smaller companies have less economies of scale, less complex capital structures, less debt and lean more on a competitive advantage, which can quickly change. What it all boils down to is that smaller companies are more risky and the investor is compensated for that risk in the long run. This works just the same way a bank demands a higher interest from a person with a lower credit score or a higher risk of default. The market demands that same kind of compensation.
Below is a scatter-plot showing the risk of each investment, plotted against the return. Notice that the small stock index has more risk, (being further to the right) but a higher return as compensation for that risk relative to the S&P 500.
Small cap stocks should not be a centerpiece for a portfolio, but certainly a building block. There is a case for small cap stocks outperforming larger stocks, but we need to remember that larger stocks tend to be more stable, which is why investors, over the long run, are compensated less. Of course, over short periods of time, we could expect small cap stocks to be punished more by the market for not being stable. We could say that many smaller companies’ stock prices reflect the potential for growth or future cash flows while larger firms typically have more established assets, which generate cash flows more steadily.
In this way, a solid investment portfolio will include small cap stocks in relatively modest amounts, while core holdings will be built using larger stock funds and bond holdings. Small cap stock funds are typically considered satellite holdings.
Building With Small Cap Funds
“Investing has and always been, and will remain, an operation in which wealth is transferred from those without a working knowledge of the financial history to those who have one.” William Bernstein
Knowing your history is the key to building a portfolio that will get you to retirement and into retirement. Small Cap stocks have a place in portfolios. They are riskier than other investments and therefore should be limited in even the most aggressive portfolio. Where your personal portfolio falls in the risk spectrum is up to you, but should be based on the reality of your situation and not an attitude or appetite for risk and speculation.