Why a style blend of small- and mid-caps may belong in a DC plan

Style investing is an investment approach that involves selecting securities based on certain characteristics or styles; this may include factors such as value, growth, momentum, size or quality. By targeting specific styles, investors aim to achieve higher returns or lower risk compared to the overall market.  

For example, value investing involves selecting stocks that are undervalued by the market with the expectation that their price will eventually rise to reflect their true worth. By contrast, growth investing entails selecting stocks of companies that are expected to grow at a faster rate than the overall market. 

The US economy maintained an unprecedent level of low interest rates over the past decade, which led to higher stock valuations. This happened because investors were willing to pay more for future earnings growth because they believed the value of future earnings would be more attractive than bond yields, which were relatively less attractive in a low interest-rate environment. This benefited growth stocks in particular, given their predominantly higher earnings growth expectations. As Figure 1 illustrates, growth dominated value while interest rates were low.

Figure 1: Style factors have dominated recently (Growth vs. Value relative to Fed Interest Rates)

Source: FactSet. Data as of June 30, 2023. Historical trends are not a guide to future results. 

After years of low inflation and zero interest rates, we believe a regime shift is underway. Persistently higher interest rates could adversely affect financial markets. In light of this, we think a renewed focus on risk adjusted returns, rather than speculative growth is warranted. Past levels of stock market returns may be difficult to achieve, especially if portfolios are constrained to one investment style. We believe a blend/core strategy that focuses on small- and mid-cap stocks could be advantageous now in DC plans. 

We’ve identified a number of potential benefits to adopting a style blend that incorporates small- and mid-cap stocks: 

Flexibility: With a blend or core investment approach, it’s possible to gain exposure to the entire small- and mid-cap market. Such latitude may be well-suited to the new economic environment.  

Moreover we believe there are benefits to blend/core investing that pertain to investing in US small- and mid-caps. A blend/core fund may be appealing to DC plans given their long-term investment horizon. Trying to tactically time when to invest in a particular style can be very difficult, if not impossible. In addition, DC plans typically choose one fund manager for their US small- and mid-cap allocation; incorporating a core/blend style could work well in this scenario. 

Reduced volatility: Because blend investing includes both growth and value stocks, it may be less volatile than a portfolio that focuses solely on growth or value. This can make blend investing a more attractive option for investors who seek to balance capital appreciation and risk mitigation. 

Because small-cap companies can be more volatile and unpredictable than larger firms, focusing on either small-cap growth or small-cap value can be risky. Blending investment styles provides a more balanced approach to changing market conditions and changing company fundamentals. 

Diversification: Blending investing styles could provide diversification benefits by combining elements of both growth and value investing. By diversifying across different investment styles, investors can potentially benefit from market upswings while also mitigating the risk of market downturns relative to a pure growth or value investment. Figure 2 shows how growth and value styles tend to concentrate portfolios into two main sectors. This can add unintended risk to a portfolio that we don’t think will be rewarded looking forward. 

Opportunity: Small-cap companies often have greater potential to grow than their larger-cap counterparts. Blending investment styles may help capture this growth potential while also providing exposure to undervalued companies that may have strong fundamentals. 

Figure 2: Core has less concentration/less exposure to risk than growth or value

Source: FactSet. Benchmark is Russell 2000. Value top two sectors: Financials and Real Estate, Growth top two sectors: Health Care and Technology. Core top two sectors: Health Care and Industrials. (RH) data as of May 31, 2023.

We believe we’re in a stock-picker’s market that requires careful analysis of winners and losers among companies. Strategies such as style investing may have worked in the past when the cost of capital was low but we believe successful investing now calls for a different approach. We think active management is well-suited to the in-depth analysis needed to uncover small- and mid-cap companies that are poised to grow and add value. The freedom to invest in any company is also important. In the philosophy of blend or core investing, we think a company’s status as growth or value is irrelevant and managers should seek to choose the most promising small- and mid-cap equities regardless of style or other characteristics.