As we consider options in the environment ahead, investors should look to a smart beta, small-capitalization stock exchange traded fund to capture the growth potential of the smaller segment of the equities market and hone in on factors that could potentially enhance returns and diminish risks.
On the recent webcast, Power up Your Small Cap Portfolio: A Factor-Based Approach to Small Caps, Marc Chaikin, CEO of Chaikin Analytics, started off by explaining that factors can be thought of as any characteristic relating to a group of securities that can help explain their risk and return. Of the various factors available, the most common that have been identified historically include size, value, quality, momentum and volatility.
While investors can focus on single factors at a time, individual factors have exhibited cyclical trends from year to year, so getting the right timing can be difficult. On the other hand, Chaikin argued that combining multiple factors could create a more diversified solution to enhance returns over longer periods.
“While factor performance has historically been cyclical, most factor returns generally are not highly correlated with one another, so investors can benefit from diversification by combining multiple factor exposures,” Chaikin said. “Factors can be combined into one strategy, potentially enhancing returns and/or managing risk across a variety of market environments.”
Salvatore Bruno, Chief Investment Officer and Managing Director for IndexIQ, also pointed out that investors should focus on the size factor, notably small-capitalization stocks, ahead. Along with small-caps’ historical outperformance to large-caps over time and their ability to recover faster from downturns, smaller companies have historically outperformed large-caps during periods of rising rates, which is especially relevant as the Federal Reserve considers hiking interest rates two more times this year.
“Rising rates often accompany high growth expectations, and small caps have historically grown faster as they grow off of a smaller base,” Bruno said. “Small caps typically have less debt, so earnings are generally less impacted by rising rates.”
Furthermore, small-caps are more focused on the domestic economy, so they are more insulated from foreign exchange currency moves that may affect large multi-national companies and are less affected by global events.
Investors interested gaining exposure to small-capitalization stocks while honing in on historically proven factors may consider the recently launched the IQ Chaikin U.S. Small Cap ETF (NasdaqGM: CSML), which tries to reflect the performance of the Nasdaq Chaikin Power US Small Cap Index.
The underlying index applies a shareholder yield screen and the so-called Chaikin Power Gauge, a quantitative multi-factor model that tries to identify securities that are expected to outperform their peers, to select components from the Nasdaq US 1500 Index. The target focus will include small capitalization stocks.
Chaikin explained that the Power Gauge’s factor-based model combines four primary factors, including value, growth, technical and sentiment to select stocks with potential to provide enhanced returns over time.
The value factor includes LT debt to equity ratio, price-to-book value, return on equity, price-to-sales ratio and free cash flow. Technical factors include price trend, price trend rate of change, Chaikin money flow, relative strength vs. market and volume trend. Growth factors include earnings growth, earnings surprise, earnings trend, projected p/e ratio and earnings consistency. Lastly, the sentiment factor includes earnings estimate trend, short interest, insider activity, analyst ratings and industry relative strength.
Financial advisors who are interested in learning more about the Chaikin small-cap strategy can watch webcast here on demand.