Making a more diversified US equities portfolio pay off
In the face of continued volatility, a more cautious stance by the US Federal Reserve (Fed) on rate cuts in 2025, and hard-to-predict markets globally, equity investors are focusing more sharply than ever on diversifying their exposure, both by sector and size of company.
Put simply, this suggests more momentum behind the rotation out of the mega-cap tech stocks which have dominated portfolios over the past 12 to 18 months. Instead, capital will likely flow into segments of the US market that should benefit from the expected growth-oriented policies in 2025 and beyond.
Against this backdrop, smaller – and often more domestically focused – companies look set to be the potential winners. In turn, investors should rethink how and where they get exposure.
Macro support for small-cap stocks
The impact on demand for US equities will depend on how investors perceive the Fed's latest plans, according to recent statements, to only make two rate cuts this year due to stubborn inflation and a resilient labour market.
Yet while higher rates generally make US bonds more attractive compared with equities, the potential for the Fed’s cautious approach to lead to a stable economic environment could boost investor confidence in US equities. Further, if the Fed’s strategy effectively controls inflation, it could lead to a more favourable investment climate for stocks
This has the potential to fuel the desire among investors to diversify into smaller listed companies as the broad rate-cutting cycle continues in many developed economies.
“Until late 2024 we saw a distinctive pattern: when rates were going down, smaller caps did better than larger caps,” said Mark Barnes, Head of Investment Research for FTSE Russell in the Americas.
In the US, for example, this led to a boost for small-cap stocks. “Compared to larger companies, small-cap businesses tend to have more floating-rate loans versus fixed-rate debt,” explained Catherine Yoshimoto, Director, Product Management, at FTSE Russell. “As such, many small-cap firms will see their existing loan payments shrink as interest rates decline.”
In general, with rate cuts creating better – and cheaper – access for smaller firms to funding, there is more potential to spur innovation, with small-cap companies more likely to invest in research and development. Further, there is a knock-on effect on the local economy as small-caps may look to hire more employees.
For investors, a thriving group of small-caps that attracts more capital offers growth potential and diversification for portfolios.
At the same time, a Trump 2.0 era also bodes well for small-caps – an impact Barnes said he saw immediately after the election result, when they outperformed large caps during November.
More specifically, based on policy pledges becoming reality, certain domestic sectors of the US economy which form a key part of the small-cap universe stand to gain. For example, explained Barnes, cyclicals have been performing well so far, as have US financials amid speculation of a relaxation in regulations. Also in the small-cap space, energy as a sector, along with smaller pharmaceutical businesses, also have potential to flourish, he added.
Capturing small-cap success
The performance of the Russell 2000 Index in the much of the second half of 2024 reflects the response of small-cap stocks to these macro dynamics. This is to be expected, given that about 80% of revenue from the Index’s constituents comes from within the US, making it more sensitive to domestic policies and the economy.
For example, said Yoshimoto, amid optimism in July 2024 about the pace of forthcoming rate cuts, the Index jumped more than 11% in just five trading sessions. Further, over the three-month period ending September 30, the small-cap benchmark rose more than 9%, outpacing its larger-cap counterpart, the Russell 1000 Index, which gained just 6%.
Meanwhile, the final quarter of 2024 saw the Russell 1000 outperform the Russell 2000 2.7% to 0.3%. Even though the Fed cut rates, long yields backed up on the expectations of fewer rate cuts in 2025.
More broadly, there is a good long-term investment case for small companies, which have delivered a long-term return premium, although their performance is cyclical.1
According to Emerald Yau, Head of Equity Index Product Management for FTSE Russell in Asia Pacific, this mirrors the focus of the Russell 2000 Index since its launch in 1984 – to consistently capture the investable opportunity set of innovative US smaller companies.
“In doing so, the Russell 2000 has helped index users to measure the small-cap premium and to gain early exposure to many future equity market winners,” Yau explained.
Key examples include: Amazon, which entered the Russell 2000 Index in 1997 before moving to the Russell 1000 Index the following year; Nvidia, which entered the Russell 2000 Index in 1999 before moving to the Russell 1000 Index in 2000; and Netflix, which entered the Russell 2000 Index in 2002, and spent seven years there until moving to the Russell 1000 Index in 2009.
Investors can also look to capitalise on the Russell 2000 via derivatives as a hedging tools. For instance, the Tokyo Financial Exchange launched Russell 2000 futures in September 2023, and Russell futures listed on CME can be traded 23 hours a day. Further, Asian investors can also access related options on the Chicago Board Options Exchange.
“The ability to access and/or trade derivatives allows investors in this region greater flexibility and responsiveness to market movements across different time zones, therefore enabling investors to react to market volatility,” added Yau.
Investing differently by design
For investors seeking diversification in the US, it is also important to address a common misperception that two indexes covering the same market segment must, essentially, be interchangeable.
“The truth,” said Yoshimoto, “is that not all indexes are created equal. Every index is the product of choices involving market coverage, construction methodology and ongoing maintenance of the member list. As a result, indexes perceived to be comparable can have profound, even surprising, differences.”
The Russell 1000 Index, for instance, is designed in a way to provide investors with a straightforward and transparent methodology. It also allows quarterly IPO additions so that newly-listed US stocks which meet the Index criteria can be included prior to the reconstitution of the Russell Index series.
“This gives investors greater precision and earlier access to fast-growing stocks,” said Yoshimoto. “it shows that, in short, your index matters.”
Russell US Indexes Fast Facts:
• Launched in 1984, representing a history of over 40 years
• Tracked by over $10 trillion USD of AUM as of the end of 2023
Click here to view more insights about the Russell US Indexes
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