Concerned About Interest Rate Risk? Consider Small-Caps
How might rising rates affect small-caps?
There's a surprising aspect to small-cap stocks that many investors aren't aware of. And that's that it has lower interest rate sensitivity than large-caps. Actually, if you measure it, and you look at the correlation, small-cap stocks have roughly half the correlation to high-grade bonds that large-caps do.
You might wonder why that is? And there's a couple of reasons. There are higher yields in large-cap stocks, more dividend paying large-cap stocks.
But I think the largest reason is that small-caps are more attuned to the domestic economy, and they tend to be a little more cyclical than large-caps. When do interest rates rise in the U.S.? Well, generally when the economy is doing better. So, if interest rates are rising and the economy is doing better, that's an environment where domestically-oriented small-caps can do better as well.
What might happen if bonds decline?
Let's look at the last two calendar years where the bond asset class actually had a decline.
Those were 2013 and 1999. In both of those years, small-cap outperformed large-cap, actually pretty considerably. So, a rising interest rate, falling bond year, can actually be a pretty decent year for small-cap.
How might this affect portfolio positioning?
So, let's think about two different portfolios. The first portfolio doesn't have small-caps; say 60 percent large-cap, and 40 percent high-grade fixed income.
The second one has just 40 percent large-cap, 20 percent small-cap, and again, 40 percent high-grade fixed income. And let's see how they did in periods when interest rates rose, say by one percent or more.
What you find is, in most of those periods when interest rates were rising, the portfolio with small-cap outperformed. So, if you're looking to reduce your interest rate risk because you're concerned about rising rates, you might want to consider adding small-caps.
Important Disclosure Information
The thoughts and opinions expressed in the video are solely those of the persons speaking as of January 5, 2017 and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.
The Bloomberg Barclays US Aggregate Bond Index is an unmanaged, capitalization-weighted index of investment grade, US dollar-denominated, fixed-rate taxable bonds. The (Center for Research in Security Prices) CRSP (Center for Research in Security Pricing) equally divides the companies listed on the NYSE into 10 deciles based on market capitalization. Deciles 1-5 represent the largest domestic equity companies and Deciles 6-10 represent the smallest. CRSP then sorts all listed domestic equity companies based on these market cap ranges. By way of comparison, the CRSP 1-5 would have similar capitalization parameters to the S&P 500 and the CRSP 6-10 would have similar capitalization parameters to those of the Russell 2000. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. The past performance shown above is not indicative of future performance.
The Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.
This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus .)
