Use Two Factors to Position For a Small-Cap Rebound | ETF Trends

Small-cap stocks and ETFs have been torched along with their large-cap peers during the recent bout of market volatility, but investors should ignore smaller stocks as a possible leadership when the coronavirus issue is contained.

An avenue for investors to position for a small-cap rebound is by putting factors to use and the VictoryShares MSCI USA Small Cap Value Momentum Blend Index ETF (NYSEArca: USVM) does that by offering duel factor positioning.

USVM identifies stocks with attractive valuations and positive price momentum and weighting the two factors in such a way to help investors diversify against the risk of individual holdings. Academic research suggests that focusing on stock companies with factors like attractive valuations and improving momentum has led to higher excess returns.

“If done properly, combining value and momentum can help reduce exposure to value traps–stocks that look cheap but have deteriorating fundamentals,” said Morningstar analyst Alex Bryan in a recent note. “It might also reduce exposure to frothy areas of the market. This could be particularly helpful among small-cap stocks, which are more susceptible to mispricing than their larger brethren. Value and momentum strategies have tended to work the best among the smallest stocks–at least on paper.”

Understanding USVM

Momentum investing can target those companies that are exhibiting high levels of growth. The momentum factor selects company stocks that have recently outperformed based on the idea that “the trend is your friend” and that stock market leaders typically continue to outperform. This type of strategy can be an effective way of targeting growth-oriented companies since stocks with positive momentum often continue to generate strong earnings.

Value stocks, or companies whose shares trade at a low multiple to their book value or net worth, have recently experienced the largest divergence in performance from growth-focused stocks this decade. Buying cheap value stocks has been a poor investment strategy for most of the past 10 years as the growth style outperformed. For instance, the S&P 500 Growth Index has outperformed its value counterpart by over 80 basis points for that period, discouraging many value investors. However, some are convinced that the approach is due for a resurgence, especially as the stock rally slows down after reaching a record.

USVM’s focus “gives the fund cleaner exposure to value and momentum than multifactor funds that target more factors,” said Bryan. “Researchers have known about these bedrock factors since the early 1990s, and they’ve paid off out-of-sample and outside academia, which breeds confidence they are likely to persist and not just the product of data mining. Despite its focus, the fund still offers good diversification because value tends to work well when momentum doesn’t and vice versa. Over the long term, both factors have good records, though the past decade has been unkind to value.”

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.