By Todd Shriber via Iris.xyz

On its own, size is one of the most widely followed investment factors and one used to illustrate the historical out-performance of stocks with smaller market values over large-cap equities. While small size is its own factor, hundreds of active and passive funds marry small-cap stocks with another factor, usually growth or value.

“The payoff to most investment factors has historically been the greatest among the smallest stocks. This may be because they are more likely to be mispriced than larger stocks,” said Morningstar. “So—all else equal—funds that start with a universe of large- and mid-cap stocks (as most multifactor funds do) likely have less poten­tial to outperform than those that start with an all-cap universe or a group of small-cap stocks.”

Speaking of multi-factor funds, the proliferation of such funds across the exchange traded funds (ETFs) landscape encompasses small-cap stocks. The JPMorgan Diversified Return U.S. Small Cap Equity ETF (JPSE) brings multi-factor investing to small caps, utilizing the value, quality and momentum factors in its security selection process.

A multi-factor approach to small caps can potentially limit some of the risks associated with single factor. For example, small-cap growth can be a particularly potent combination, but it can also expose investors to elevated volatility and larger drawdowns in bear markets. Small-cap value historically produces enviable long-term returns, but some studies suggest that there are periods in which the cheapest small caps (based on price-to-book) underperform. An index of small-cap stocks focusing on the low volatility factor may serve the end of reducing volatility but lack the ability meet an investor’s upside capture requirements.

Although many of the funds are fairly new, real world applications of multi-factor small-cap ETFs show promise. Since inception in mid-November 2016, the JPMorgan Diversified Return U.S. Small Cap Equity ETF has easily outpaced competing small-cap low volatility and value strategies.

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