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By Alex Bryan, CFA and Christine Benz | 08-16-2017 02:00 PM

Why Factor Investing Works Best With Smaller Stocks

Strategies targeting factors like value and momentum seem to work better with small-cap equities thanks to more potential for mispricing, says Morningstar's Alex Bryan.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The performance of certain market factors looks even more compelling when applied to the small-cap space than it does for the market at large. Joining me to share some research on this topic is Alex Bryan. He is director of passive strategies research for Morningstar in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Let's talk about your research in Morningstar ETFInvestor and what you found about how investors should apply factors in the small-cap space.

Bryan: I did some research and found that targeting stocks with certain characteristics or factors like low valuations, low volatility, strong recent performance or momentum, while these strategies have produced higher returns than the overall market, they have tended to work the best among the smaller stocks and the worst among the largest stocks. I think the reason for this is that small-cap stocks are more likely to be mispriced than large-cap stocks.

So, if you take value, for example, targeting stocks with low valuations, there's one or two reasons why stocks with low valuations have historically offered higher returns than their more expensive counterparts. One is that investors may extrapolate past growth too far into the future. And if you think about small-cap stocks, these tend to be less widely followed by market analysts because there are just fewer analysts covering them. And so, the potential for these mispricings, I think, is larger in the small-cap space which I think creates these opportunities for value stocks to offer higher returns in the small-cap space than they do in the large-cap space.

There's a similar argument, I think, you can make for momentum. Momentum is kind of based on this idea that investors are slow to react to new information in the market. And if small-cap stocks don't have as much informational efficiencies because there aren't as many research analysts following these things, then it can take even longer for new information to be incorporated in stock prices in the small-cap space than in the large-cap space.

So, for those reasons, I think, that's why we see the factors tend to work the very best among the smaller stocks.

Benz: Let's take a look at some of the factors where the evidence is particularly compelling that if you want to play this factor, you should maybe be looking at some sort of a small-cap product. Let's start with small value. You say the case is there when you look at the data. If you want to capitalize on the value effect that looking at small caps might be a good place to do it. What sort of fund should I be looking at?

Bryan: I think keeping it really simple, the low-cost market-cap-weighted funds are a good way to go. So, one of the funds that we really like in this space is the Vanguard Small-Cap Value ETF, ticker VBR. This fund basically targets stocks that represent the cheaper half of the U.S. small-cap market and then it weights its holdings based on market capitalization. The reason that we like this fund is it's really broadly diversified. It's not as deep value as some of its peers. So, it's not going to shoot the lights out. But I think that broadly diversified portfolio will help keep risk in check and it should benefit should small-cap value stocks outperform. And I think there is a good case to believe that they will.

It is important to note, however, that value, even though it may work really well over the long periods of time, it can go through extended periods of underperformance. The last decade is a good case in point, right? Part of the reason for that is, funds like this, value funds like this, have tended to overweight financial services stocks. That really hurt performance back in 2007-08. So, you have to have tolerance for these swings in relative performance, but I think if you take the long view, keeping your costs down with a broadly diversified cap-weighted fund like this is a good way to go.

Benz: Let's take a look at low volatility. You mentioned that that's another area where the evidence points to perhaps using some sort of a small-cap product if you want to make a play on that low-volatility anomaly. And it's interesting because it seems like a lot of the money in low volatility ETFs is in the large-cap ones. But let's talk about that.

Bryan: Yeah, that's right. Low volatility, when you think about it, the largest stocks tend to be the least volatile stocks in the market, by and large. There's exceptions here and there. But if I'm a risk-averse investor, my first inclination is to look for a low-vol strategy in the large-cap space just because that's where you would expect to find the best downside protection.

Now the research has suggested that the relative outperformance is the largest in the small-cap space. So, if you compare a low-vol strategy against its parent benchmark within the same market-cap realm, that benefit is the biggest in the small-cap space. Now, it's still true that small-cap low-volatility stocks are more volatile than large-cap low-volatility stocks. But if I really believe in this behavioral anomaly and I want to take advantage of it, doing it in the small-cap realm may make sense.

So, one of the funds that we really like in this space is the PowerShares S&P SmallCap Low Volatility ETF. This fund targets the least volatile fifth of the S&P Small Cap 600 Index and then it weights its holdings based on the inverse to their volatility so that the least volatile stocks get the biggest weightings in the portfolio. It offers very clean exposure to the low-volatility effect that's been documented in the academic literature. So, if I really believe in this effect and I want to take advantage of it, I think the small-cap space is a really good place to do it.

Benz: Alex, interesting research. Thank you so much for being here to share it with us.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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