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Small-caps tend to perform well at the beginning of the year thanks to a bounce back from tax-loss selling and portfolio managers’ behaviour.

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Although U.S. small-cap stocks have underperformed stocks of larger companies significantly since mid-2018, now is the right time for savvy investors to rotate back into this asset class.

Small-cap stocks typically have much better long-term growth prospects than their larger counterparts, but investors have shied away from these shares as concerns about a significant slowdown or recession in the U.S. economy have increased. That is because small companies generally do not have the same access to capital as large companies; they also have a higher risk profile – especially in a slowing economy.

Yet, data from the past 40 years show that regardless of the economic environment, small-caps tend to outperform large-caps from Dec. 19 to March 7. The Russell 2000 Index of small-cap stocks has produced an average gain of 5.4 per cent and has been positive 77 per cent of the time during this period from 1979 to 2019. In contrast, the Russell 1000 Index of large-cap stocks has produced a lower average gain of 2.7 per cent and has only been positive 70 per cent of the time. Furthermore, small-caps have outperformed large-caps 68 per cent of the time in this period.

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This seasonal strategy, which I have named the small-cap effect, is an extension of the well-known and often publicized January effect, which posits that stocks tend to perform well in January as they rebound from artificially low prices caused by tax-loss selling in December. The January effect has been particularly effective with small-caps as investors are more likely to sell small-caps in December to generate losses to offset any capital gains realized during the year.

One of the major differences between these two seasonal strategies is that the small-cap effect begins earlier and ends later than the January effect. One of the major reasons why the small-cap effect starts earlier is that, over time, investors have tried to front run the January effect, which is one of the best-known seasonal trades in the market and receives a lot coverage from the investment media and brokerage houses as year-end approaches.

Brooke Thackray, research analyst, Horizons ETFs (Canada) Inc.

PIERRE GAUTREAU/Handout

Thus, the “ideal” entry date into the small-cap sector has shifted to mid-December from the end of December, which is the entry date for the January effect, as some investors have tried to get into the small-cap sector before there is a large degree of investor interest caused by articles on the January effect.

Small-caps tend to perform well at the beginning of the year not just because of a bounce back from tax-loss selling, but also because of portfolio managers’ behaviour. Most portfolio managers are compensated based on how well they perform relative to their benchmark. As a result, they are more likely to take on greater risk, including putting money into small-caps, at the beginning of the year.

If portfolio managers are able to exceed their benchmark at the beginning of the year, they can “coast” knowing that they have exceeded their benchmark for the year. I call this phenomenon “beta out of the gate and coast.” On the other hand, if portfolio managers fail to outperform their benchmark early in the year, they have the remainder of the year to catch up and exceed their benchmark.

For investors looking to use an exchange-traded fund (ETF) to take advantage of the small-cap effect in the U.S. market, iShares Russell 2000 ETF (IWM-A) and SPDR Portfolio Small Cap ETF (SPSM-A) should be considered.

Although the small-cap sector is expected to perform well in its seasonally strong period, different industry groups within it are expected to have varying performances depending on what is taking place in the markets. This is particularly true for industry groups that have a greater potential to benefit from tax-loss selling. For example, although stock markets in both the U.S. and Canada have had strong double-digit returns thus far in 2019, Canada’s energy sector has lost ground and could be particularly attractive for investors during the small-cap effect period. That is particularly true for small-cap energy stocks.

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Brooke Thackray is research analyst at Horizons ETFs (Canada) Inc. He focuses on technical analysis and seasonal investing.

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