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Long Story Short: Smallcap Stocks Can Increase Your Portfolio’s Diversification
Can Smallcap Funds Help Cap Index Overlap in Your Portfolio?
Fund Overlap arises when an investor owns two or more mutual funds that invest in similar parts of the market. Indexes will normally hold a high percentage of the top-performing companies in their particular sector, so by holding two similar funds, an investor is bound to have some sort of overlap. This overlap reduces the benefit of diversification and increases your exposures. The simplest way to detect and avoid overlap is to look at your investment categories and consistently check, as funds may deviate from their original style.
Smallcap Differentiation. The bulk of US equity assets are tied to largecap-dominated indexes like the S&P 500. Investors argue that the amount of capital poured into the most popular index funds creates liquidity risk. For this reason, smallcap stocks are attractive because they tend to be underrepresented in indexes. Largecap funds are much more concentrated; for instance, 21.7% of the S&P 500’s weighting is in its top 10 participants, while the top 10 stocks in the Russell 2000 Index (a smallcap stock market index) account for only 2.9%. As a result of being underweighted in indexes, smallcap stocks or funds can aid investors in diversifying their portfolios and avoiding fund overlap.
High Active Share. Active share measures the percentage of a fund’s holdings that are different from its benchmark index. It determines the extent of active management conducted by a portfolio manager, and research shows funds with high active share outperform their benchmark. Most smallcap funds have a high active share, normally in the 95%-100% range, which results from smaller funds being more equally dispersed. Although it is not considered a proxy for excess return, the two have been shown to be positively correlated.
Timing. Smallcap stocks provide great growth potential, but you cannot always expect a quick flip. Companies with lower market caps are normally young entities emerging into the market or ones creating an entirely new sector altogether. Either way, these are investments that take time and at first, may be less liquid than more common companies. Focusing on smallcap stocks can move an investor away from the majority of indexed equity assets, but it would mean targeting a part of the market that brings its own risk factors.
Diversification is Key. Major indexes are investors’ benchmarks for their portfolios’ performance, which in many cases cause funds to be weighted in similar fashions. When investors buy into funds that are closely related, they lower their diversification, which increases their exposure, and they might not even know it is occurring. Smallcap stocks are weighted less in major indexes and can provide differentiation to portfolios to avoid some of the overlap, but be aware, they come along with their own set of risks.
https://www.morningstar.com/articles/945334/can-active-small-value-funds-save-you-from-index-overlap, Kevin McDevitt, September 10, 2019
https://www.thebalance.com/what-is-fund-overlap-2466462, Kent Thune, May 6, 2019
https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/leadership-series_active-share.pdf, Fidelity Investments, February 2014
https://www.investopedia.com/articles/mutualfund/07/active-share.asp, Jerry Sais Jr. & Melissa W. Sais, March 19, 2018