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Advantages and disadvantages of US small-caps

This article is part of
Guide to US small and mid-cap funds

Advantages and disadvantages of US small-caps

The US stock market may be one of the richest and most diverse in the world but investors are still cautious about going below the largest listed companies.

According to respondents to this guide, apart from a lower dividend yield as many smaller stocks are growth-focused instead of income-generating, key concerns include lower liquidity, less analyst coverage and greater risk on the downside with small-cap companies.

Jenny Jones, head of US small and mid-cap equities for Schroders, says the “primary disadvantage” of investing in small cap compared with large cap is the lower levels of liquidity and higher volatility than large cap.

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Extrapolating returns back from the period January 1979 to March 2016, the standard deviation of returns for the Russell 2500 is 18.18 per cent, she said.

For the S&P 500 index of large-cap stocks, the standard deviation is 15.08 per cent. “Small to mid-cap as an asset class has more than 300 basis points higher standard deviation so this is a riskier asset class”, she says.

However, for a UK investor, small in the US does not necessarily mean the same as small in the UK.

Some US small and mid-caps are equal in size to some UK large-cap companies, as Darius McDermott, managing director of Chelsea Financial Services, has pointed out.

He says this could be both an advantage - in terms of better liquidity - and a disadvantage in that underlying holdings in US small cap funds “may not be the really small companies you think you are getting”.

Policy matters

There are also concerns the US smaller-cap sector is more volatile, reacting more strongly to policy decisions made by the US Federal Reserve or political pronouncements, for example.

Robert Siddles, manager of the £159m Jupiter US Smaller Companies trust, explains: “US small caps are higher beta than large caps, as their daily reaction to events will generally be greater.

“The main driver to their performance as a sector is sentiment to the economy: they outperform when economic prospects are viewed to be improving. What the Fed says or does is only part of investors’ views as they may interpret the Fed according to their mood.”

He says historically, US small caps have tended to do well in the months after the first Fed rate rise and better after the second, as it usually means the economy is doing well.

“Once the Fed slams on the brakes because inflation is too high”, Mr Siddles adds, “a recession becomes more likely and equities, including small-caps, turn down.”

The view of Francis Gannon, co-chief investment officer of The Royce Funds, is the correlation between economic policy developments and the performance of small caps is more sector than market-cap specific.

Mr Gannon says: “It is hard to generalise as each company is different but I think the correlation tends to be more pronounced by industry and sector.