Small cap U.S. indexes have a history of outperforming big cap indexes from the middle of December to at least the end of February. Will the "small cap effect" happen again this year?
Thackray's 2013 Investor's Guide notes that the Russell 2000 Small Cap Index outperforms the Russell 1000 Big Cap Index from Dec. 19 to March 7. The Russell 2000 Index has gained in 26 of the past 33 periods for an average gain per period of 5.7 per cent. It also outperformed the Russell 1000 Index by an average of 3.2 per cent per period.
Small cap equities and exchange traded funds tend to come under pressure during October, November and early December each year due to a series of annual recurring events. Tax-loss selling pressures by individual investors take their toll during this period. In addition, year-end "window dressing" by institutional investors has a negative influence. Institutional investors prefer not to show large holdings in "high beta" small cap stocks when they release their annual reports. As well, institutional investors, who are having a profitable year, often prefer to own big cap stocks with lower volatility near year end as the time for calculating their final performance bonus approaches.
Weakness until mid-December normally sets the stage for a significant recovery in the small cap sector near year end. Frequently, the recovery starts during the traditional Santa Claus rally period from Dec. 15 to Jan. 6. Tax-loss selling pressures are relieved. In addition, institutional investors start to look for equities with higher risk and greater potential return to set the stage for potential outperformance in the following year. Top candidates frequently are found within the small cap sector.
The small cap sector is in a better position for outperformance in early 2013 than the big cap sector and its focus on international markets. The U.S. currently is the leader in economic growth among developed nations including Canada. Earnings by companies with smaller capitalizations in the U.S. will benefit from low short-term interest rates. The Federal Reserve's quantitative easing programs assure that low short-term rates will continue until 2015. A resolution of the "fiscal cliff" will set the stage for accelerated earnings gains as the year progress.
Small cap indexes are showing strength earlier than usual this year. Strength of the Russell 2000 Index relative to the S&P 500 Index and Russell 1000 Index turned positive in mid-November. The Russell 2000 Index at 827 trades above its 20-, 50- and 200-day moving averages. Preferred strategy is to accumulate Small Cap ETFs at current or lower prices.
Several small cap exchange traded funds are available. The most actively traded U.S. small cap ETF is the iShares Russell 2000 Index. Units track performance of approximately 2,000 smaller cap U.S.-listed equities that are part of the broadly based Russell 3000 Index. Management expense ratio is 0.28 per cent. Canadian investors can choose to purchase a hedged version by owning the iShares Russell 2000 Index traded on the Toronto Stock Exchange. Units trade in Canadian dollars and are fully hedged against a decline in the U.S. dollar. Management expense ratio is 0.35 per cent.
iShares offers the second most actively traded U.S. small cap ETF, the iShares S&P Small Cap 600 Index. Units track the performance of the 600 small cap U.S.-listed securities that are part of the S&P 1,500 Index. Management expense ratio is 0.16 per cent. Vanguard also offers a low cost ETF. Management expense ratio on the Vanguard Small Cap ETF is 0.16 per cent. The ETF tracks the performance of the MSCI U.S. Small Cap 1,750 Index.
iShares offers a small cap exchange traded fund consisting of Canadian stocks in the TSX composite Index. Units track the performance of S&P/ TSX composite stocks excluding S&P/TSX 60 stocks. Management expense ratio is 0.55 per cent.