GLOBAL SMALL CAP INVESTMENT SOLUTION: RISK, REWARD AND SOURCES OF ALPHA
EXPANDING INVESTMENT SPECTRUM FOR FINANCIAL ADVISORS
The QAS S-130 Global Small Cap with Protection Strategy Index mentioned in this article is currently licensed to a U.S. asset management company.
For more information please visit www.qas-service.com
Expected Return and Global Approach
US financial advisors often overlook small cap equities in order to avoid high-risk investments in their portfolios. This is especially true for the international small cap segment because it presents additional risks that have to do with currency fluctuations, geo-political events and other factors.
Intuitively, these markets are harder to understand and require extensive analytical work for financial advisors, especially true when dealing with international markets.
However, there are several reasons why investors around the globe pay attention to the small cap stocks across all countries and regions. A simple relative performance analysis shows that small caps periodically present significant opportunities as compared to the large cap benchmarks (traditionally, a core stock universe for US investors). Using the US Small Cap benchmark as an example, we can see that there were many periods of time when small cap stocks significantly outperformed a standard core portfolio benchmark – S&P 500 index (see Graph 1 below).
The actual 10-yr mean annualized return of the IWM ETF is almost the same as SPY, +23.7% vs. +23.1% respectively. It is also clear from the graph that the small caps dominated during the 2010-2015 strong bull market period (double digits excess return), while losing ground on a relative basis during corrections.
We can make the assumptions that small cap stocks a) carry the expected return similar to that of large cap stocks, and b) can become a good source of alpha, especially during strong bull market periods.
Graph 1. Russell 2000 (IWM) vs. SPDR S&P 500 (SPY) 2009-2019
Source: Bloomberg <PORT>
Further, we would like to expand our “search for alpha” into other regions. There are two US-listed ETFs that attracted our attention as being a good global representation of the small cap segment beyond the US: (1) SCZ – iShares MSCI EAFE Small Cap (Developed Markets) and (2) EWX – SPDR S&P Emerging Markets Small Cap (Emerging Markets). We found some evidence of the periodic outperformance on a relative basis, and therefore there is good potential for additional alpha generation.
On graphs 2 and 3 below you can see an illustration of the outperforming periods when the “developed” and “emerging” markets small cap indexes had strong excess return over the US small cap index.
This analysis led us (QAS) to the idea of developing an ETF-based global small cap strategy for US financial advisors.
Graph 2. iShares MSCI EAFE Small Cap (SCZ) vs. Russell 2000 (IWM) 2015-2019
Source: Bloomberg <PORT>
Graph 3. SPDR S&P Emerging Markets Small Cap (EWX) vs. Russell 2000 (IWM) 2017-2019
Source: Bloomberg <PORT>
Additional Sources of Alpha
Now that we have already covered our “global small cap” exposure approach (US, Developed and Emerging Markets) we will discuss two additional and very important sources of alpha that are used in this strategy.
For this project we set an ambitious goal of incorporating some investment instruments that are normally ignored by advisors due to their high-risk parameters or complexity. The QAS methodology allows us to create a multi-regime portfolio structure where we can identify specific market conditions from which we can take advantage of such instruments as 2X Leverage ETFs and Commodity ETFs for additional alpha generation.
As a result, we created a five-regime allocation scheme that utilizes three distinct sources of alpha:
- Global Small Cap instruments rotation
- 2X Leverage
- Downside protection with Treasury and Gold instruments
QAS S-130 Global Small Cap with Protection Index’s Regimes
Downside Protection in 2018
The best illustration of the alpha generation process was an activation of Regime 4 during October – December 2018. The strategy was able to reduce draw down to a minimum and allowed for a faster recovery during January-February 2019.
Source: Bloomberg <PORT> and QAS Production
Overall, the QAS S-130 Global Small Cap with Protection Index’s methodology takes into consideration all aspects of “Global Small Cap” investing and allows for a solid “opportunity-driven” and “risk-controlled” portfolio construction process. This approach provides investment advisors with a unique investment strategy for a maximum upside potential as well as a gradual portfolio protection mechanism.
QAS – expanding the investment advisor’s spectrum one strategy at a time!
