Advisors increasing allocations as small-caps rally

For the first time in a long time, financial advisors are thinking small.

The Russell 2000 is finally narrowing the gap against its big-cap brethren after more than a year of severe underperformance. The small-cap index is up 17.7 percent and 21.1 percent, respectively, over the past 6 and 12 months, compared to the S&P's return of 21.3 and 33.2 percent over the same periods.

The narrowing delta between the two indexes in the last year has a number of wealth managers thinking a change of leadership may be at hand, and as a result they're shifting more funds from the market’s whales to its minnows.

Greg Tuorto, portfolio manager of the Goldman Sachs Small Cap Core Equity ETF (GSC), believes the entire market is on the cusp of an earnings recovery, but said it will be felt most powerfully in the small-cap space.

“Earnings had a downturn in small-caps going back to 2021, when the interest rate cycle changed. And we're starting to see an emerging consensus from the companies. Earnings are a bit better, especially for the heavily domestically focused companies like the ones we invest in,” he said. 

As for those Federal Reserve rate cuts that are supposed to benefit small companies more than larger ones, Tuorto says it's not catastrophic for his portfolio should the Fed easing continue to be delayed by higher-than-expected inflation numbers.

“As long as rates don't go much higher, then small-caps can outperform,” he said. “The companies themselves have adjusted quite well to a higher interest-rate environment. They found other ways to raise capital like convertible bonds, which is an area that they like a lot. And we do think that they've adjusted to the investment cadence that they need to have in a higher-rate environment.” 

Nathan Hoyt, chief investment officer at Regent Peak Wealth Advisors, expects interest rates to fall in the back half of the year and says a falling rate environment has historically been good for both small-cap growth and value companies.

“Small-caps are still relatively less expensive than large-cap growth companies that continue to reach fresh highs,” said Hoyt, who typically uses broad index-based funds to gain small-cap exposure except on occasions when he utilizes a tax-efficient fund manager who demonstrates extraordinary performance over 1-, 3- and 5-year periods.

Stephen Tuckwood, director of investments at Modern Wealth Management, says the chasm that has formed between large-cap and small-cap stocks is indeed compressing, making this the ideal time to put money to work. 

“Historically, when the Russell 1000 outperforms the Russell 2000 by around 20% over a 1-year period, it has been a compelling time to allocate to small caps on relative basis. Exact timing is always difficult but at some point, we anticipate that the two indices will begin to converge,” he said.

With approximately one-quarter of the Russell 2000 constituents being unprofitable, Tuckwood says his preference when allocating to small-cap stocks has been to tilt toward quality, which can be broadly defined as companies with strong balance sheets and positive cash flows.

“With our view of higher interest rates for longer ,we see the quality tilt as ever more important, given the increase in interest expenses and debt refinancing costs facing many small companies,” he said. 

Michael Rosen, chief investment officer at Angeles Investments, says he has been structurally underweight small-cap stocks for most of the past decade, primarily because of this higher rate of unprofitability, and despite the recent run in small-caps, he doesn’t plan to change his approach now.

“Our investment approach tends to emphasize profits, and small-cap stocks have generally been less profitable than large-cap stocks,” Rosen said. “Small-caps are also much more leveraged than large-caps, thus riskier, and this combination of lower profitability and greater risk has led us to a structural underweight in small-cap stocks.”