Given equity allocations are often top-heavy with an overweight to large caps, we believe there is an opportunity to move down in cap size and create a new, lower center of gravity in U.S. equity portfolios. Senior Portfolio Strategist Damien Comeaux explains.

Key Takeaways

• Longstanding equity portfolio biases leave many investors under-allocated to some of the most important exposures in a recovering economy.
• Rather than getting stuck in the growth/value analysis paralysis, investors may want to consider looking down in cap size and across sectors for potential opportunities.
• A broader equity footprint that diversifies the traditional top-heavy, large cap overweight by adding mid- and small-cap equities can potentially provide greater exposure to the reflationary trade via cyclical sectors such as industrials, financials, materials and energy.

Many of the concerns of 2021 – inflation pressures, COVID variants, and shifting monetary policy – will likely continue to dominate client portfolio discussions throughout 2022. While the last two years seem like a blur to most, it is helpful to reflect on the stark contrast of returns between U.S. equity styles.

Large-cap growth equities had the upper hand during the 2020 COVID lockdown as demand for technology soared. But once vaccines were announced in late 2020, value and lower-cap equities, with greater exposure to cyclical stocks, took over the top spot as the physical economy began to reopen. Then, in the latter half of 2021, we witnessed a tug-of-war between growth and value, exacerbated by the Delta and Omicron variants and by equity market sensitivity to interest rate and inflation headlines.

An interesting and convenient approach to understanding the unpredictable swings between growth and value is to look at the rolling one-year tracking error between the Russell 1000^® Growth and Russell 1000^® Value indices. As seen in the charts below, the volatility of the return dispersion has increased significantly post-pandemic, illustrating the increasingly contentious relationship between growth and value.

Through our consultations with financial professionals, we often see an overweight to large caps with an inherent tilt toward growth. This implicit (or explicit) growth overweight can in some degree be attributed to the information technology and communication services sectors comprising 40% of the S&P 500 Index.

Given equity allocations are often top-heavy with an overweight to large caps, we believe there is an opportunity to move down in cap size and create a new, lower center of gravity in U.S. equity portfolios. A broader equity footprint that diversifies the traditional top-heavy, large cap overweight by adding mid- and small-cap equities can potentially provide greater exposure to the reflationary trade via cyclical sectors such as industrials, financials, materials and energy.

Mid and Small Caps Provide Broader Exposure to Cyclical Sectors

Source: Morningstar, as of 12/31/21. 

Mid caps in particular are more mature business models that have demonstrated their viability and are generally less volatile than their small cap peers. When compared with large-cap companies, mid caps are often in the prime growth phase of the business life cycle, where they may be experiencing higher cash flow, revenue, and earnings growth rates.

Rather than getting stuck in the growth/value analysis paralysis, investors may want to consider broadening their sights – while understanding the risks that may be involved – by looking down in cap size and across sectors to access exposure to more cyclicals, particularly with the current inflation and a continued recovery in mind.

 

Russell Top 200 Index measures the performance of the 200 largest companies (63% of total market capitalization) in the Russell 1000 Index.