An Arrowroad View on U.S. Small-Caps

It’s a question that comes up in a volatile market: “Is my portfolio working as hard as it should be?” For our valued Arrowroad clients, seeing certain parts of the market surge while others lag can be confusing and lead to questions about the core strategy. We know people are talking about the incredible performance of mega-cap tech stocks and wondering if they’re missing out.

Academically speaking, the advice is almost always to stay the course. The science of investing is built on principles that have been tested over decades, and it confirms that reactive changes based on recent trends can often do more harm than good to long-term returns.

However, at Arrowroad, we know that investing isn’t just an academic exercise; it’s a human one. Sometimes you need to understand the “why” behind the market’s movements for your own peace of mind. Before making any decisions, it’s often best to step back and seek a clear perspective. Perhaps take a break from the financial news and enjoy the vibrant energy of Melbourne as the city heads into the Spring Racing Carnival.

To help provide that clarity, we turn to in-depth research from trusted global institutions. A recent piece from Vanguard offers a fascinating explanation for a question many investors have been asking, “What happened to the U.S. small-cap premium?”

For decades, academic research showed that smaller companies tended to deliver higher returns than their large-cap counterparts over the long run—a phenomenon known as the “small-cap premium.” However, as Vanguard’s analysis highlights, this premium has been effectively missing for the last ten years.

Vanguard identifies several key reasons for this shift:

• Sector Differences: The large-cap indexes are heavily weighted towards technology and “mega-cap growth” stocks, which have seen extraordinary returns. Small-cap indexes have far less exposure to this high-growth sector.
• Weaker Profitability: A surprisingly large number of companies in the primary small-cap index (the Russell 2000) are actually unprofitable.
• Interest Rate Sensitivity: Smaller firms have been hit harder by rising interest rates, as they often rely more on floating-rate debt.
• Changes in the IPO Market: Today, many of the most promising high-growth companies are staying private for longer, meaning that by the time they go public, they are already large-cap companies.

So, is the small-cap premium gone for good? Vanguard’s forward-looking analysis suggests not. Their capital markets model projects that U.S. small-caps are actually forecast to outperform large-caps over the next decade. The reason? Valuations. After a decade of underperformance, the valuation gap between small and large caps is significant, suggesting a potential opportunity for long-term investors.

What Does This Mean for Investors? This situation is a perfect illustration of why a disciplined, diversified approach is so critical. Chasing the hot performers of the last few years would mean abandoning asset classes precisely when they may offer better long-term value. This is the time to lean on the fundamental principles of successful investing:

• Have clear, appropriate investment goals: Your strategy is aligned with your personal timeline and objectives, not short-term market trends.
• Maintain a balanced and diversified portfolio: Diversification ensures you have exposure to different parts of the market, which will perform differently at different times. It is the most effective tool to manage risk.
• Minimise costs: Keeping investment costs low ensures you keep more of your returns.
• Maintain perspective and long-term discipline: Avoid making impulsive decisions based on the noise of today’s headlines.

Sticking to your pre-determined strategy, which was built to withstand periods like this, is paramount. The small-cap premium may have been missing, but the premium for patience and discipline is always there.

For a deeper dive into Vanguard’s analysis, we encourage you to read the full article: https://www.vanguard.com.au/adviser/learn/insights/markets-and-economy/what-happened-to-the-US-small-cap-premium

As always, please reach out for a chat with Mark about this. We are always happy to discuss how different market dynamics impact your specific portfolio and long-term plan.

The information contained in this article is general information only. It is not intended to be a recommendation, offer, advice, or invitation to purchase, sell, or otherwise deal in securities or other investments. Before making any decision regarding a financial product, you should seek advice from an appropriately qualified professional. We believe that the information contained in this document is accurate. However, we are not specifically licensed to provide tax or legal advice and any information that may relate to you should be confirmed with your tax or legal adviser.