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A Tale of Two Market Caps

It is a challenging time for advisors. Many are having tough conversations with clients, some of whom either don’t remember the pain of 2008/2009 or are young enough to have never witnessed a dramatic market downturn. While it’s easy to get caught up in the general panic, this is an opportune time to reinforce the value of asset allocation and diversification. 

Asset allocation portfolios have helped some clients weather the current volatility but communicating the thinking behind the moves you make is important to show the value you add. Consider the impact of diversification even within an overall asset class, such as domestic equity, where we examine the recent performance of U.S. large cap versus small cap stocks. While correlation during the initial dramatic drop was very high, as market volatility has lessened, correlation between the two asset sub-classes has diverged somewhat.

For example, after a second straight week of gains, its third in the last 4 weeks, the S&P 500 has rebounded more than 25% from its March lows, with returns over the past year down only 3.5%. The same cannot be said for the Russell 2000 Value Index, which has seen a sharper decline than the S&P 500 and only a modest rebound. 

Historically, the small cap value asset class has outperformed its equity counterpart’s over long periods, but the prolonged bull market saw small cap value returns substantially lagging other asset classes, specifically the S&P 500.

The good news is that small cap value performance coming out of bear markets has been strong and the asset class has, on average, since 1926, outperformed large cap for one-, three- and five-year periods following bear market troughs. Key takeaways:
• Advisors considering tactical asset allocation shifts may be looking at increasing small cap value holdings
• Small cap value managers should take advantage of this potential opportunity to market their strategy

A caveat is that the current markets are reacting to a true “Black Swan” event, the global pandemic, which does introduce a level of unpredictability. Using history as a predictive tool is imperfect, and with the uniqueness of this Black Swan event, it may not follow the historical pattern of small cap value outperformance. 

No matter the moves your firm is making, communicating to prospects and clients what you are seeing, thinking and doing in response to market events is critical for both wealth and institutional managers.