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In our team meetings, we often discuss the shifting sands of the market. Not only is it an interesting topic, but it poses a challenge for asset allocators. We are in the midst of a multi-year outperformance cycle for large-cap growth. The companies that have driven this outperformance have all become household names: Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla. The top 10 names in the S&P 500 account for roughly 32 percent of the index compared to the average since 1990 of 20 percent. During the dot-com boom, the top 10 weightings peaked at 25 percent.
But the S&P 500 is not a representation of the entire market. The Russell 3000 is a broad measure of the U.S. equity market. This index provides diversified exposure through 3,000 stocks, including large-, mid-, and small-capitalization companies. So, what has the rally in large-cap growth meant for the broad market?
As seen in the chart below, it has meant quite a bit.
Over the past 10 years, the weighting of the top 3 percent of companies known as the mega-cap part of the broad market has increased from 47 percent to 69 percent. The obvious offset to this is the contraction of the small- and mid-cap part of the market. Mid-cap has declined from more than one-third of the market to just under one-quarter, while small-cap has dropped from 15 percent to only 7 percent. That is a lot of shifting of the sands underneath the surface of the market!
The Effects on Portfolio Construction
So, how do those who construct portfolios think about those shifting sands? Here at Commonwealth, we are proponents of rebalancing as part of any investment philosophy and process. In and of itself, it is a good risk management tool. As Bernard Baruch said, “No one ever went broke taking profits.” But if rebalancing back to target allocations is all one does without considering the changes in the market, it may lead to unintended risk at the portfolio level.
For example, if 10 years ago you allocated 50 percent to mega-cap and 15 percent to small-cap, you would have had a balanced and diversified portfolio that would mirror the returns and risk of the market. If all you did was rebalance your portfolio every year back to target weightings, today you would have a portfolio that is double-weighted to small-cap, overweight mid-cap, and underweight large-cap. That is a risk too big to ignore.
The Fundamentals of Large- and Small-Cap
We also believe that the best investments over the long term have both attractive valuations and strong business fundamentals. Having tilts in the directions of asset classes is not only appropriate but also an important part of constructing client portfolios to add value. But what do the fundamentals of large- and small-cap tell us?
The prospects for AI have been the latest driver of large-cap growth’s outperformance. The large, well-known companies previously mentioned have the advantage of proprietary data and the benefits of consolidation and first-to-market. Unlike new technologies of the past, AI has been a winner-take-all end market to date. The secular growth opportunity for this part of the market is certainly exciting.
In general, small-cap companies have seen a shift in their fundamental outlook. Some of this shift has to do with the changing interest rate environment. Forty-five percent (excluding financials) of small-cap index debt is floating-rate debt. For the 10 to 15 years that interest rates were low, this was not particularly impactful. But as that debt is refinanced at higher rates, it affects companies’ ability to grow as more of their liquidity is needed to service the debt.
At the same time, roughly 40 percent of small-cap companies are unprofitable compared with just 7 percent of large-cap companies at the end of the first quarter of 2024 (per J.P. Morgan Asset Management). While it is certainly expected that some companies in certain businesses such as biotech will be unprofitable, this disparity does get to the difference in quality between the two asset classes. This could be because private companies are staying private for longer due to an abundance of private capital available. Therefore, by the time they come public, they are mid-cap if not large-cap companies. The natural replenishing of the small-cap opportunity set has slowed.
Rightsize to Avoid Risk
We believe that diversification is still the best approach to constructing portfolios from both a value creation and risk management standpoint. There is a place in portfolios for large-, mid-, and small-cap asset classes. But they need to be rightsized for the current opportunity set. This will help avoid unintended risks in portfolios.
