It has made sense to stick with small caps around recessions.

Eaton Vance, a leading global investment manager, notes global small-cap stocks investors have been worried lately about volatility, rising geopolitical risks, a potential recession and the sheer length of the current rally.

Aidan Farrell, Director of Global Small Cap Equity, Eaton Vance says “It makes sense intuitively why investors are more nervous about small caps because they tend to have higher volatility than their large-cap peers.

“While we could debate the prospects for equity markets at length, let’s assume the glass is half empty, and that global stock markets face imminent challenges ahead. In that case, many investors would have the knee-jerk reaction that small-cap equities are the last place they want to be, especially in the later stages of the economic cycle.

“However, it’s not that simple, and investors dismissing the idea of investing in small caps may be making a big mistake.

“Instead, we think global small-cap stocks deserve a place in many long-term equity portfolios. They may offer strong risk-adjusted performance versus large caps, diversification and opportunities for active managers.

“Now, we can still make a solid case for global small caps even if investors are worried about the economic cycle for any reason, including trade wars or other political risks. Trying to time exposure to small-cap stocks to avoid recessions is a loser’s game, as we’ll discuss.”

Eduardo Lecubarri and his team at J.P. Morgan produce regular in-depth research on the small- and mid-cap (“SMid”) universe. A recent piece from them studied the historical performance of SMid stocks before, during and after recession-linked market downturns.

Lecubarri looked at the last three U.S. recessions and found that SMid outperformed large-caps more often than not in some regions, including Europe and Japan.

Looking at the U.S. market, as noted in the charts below, small caps as measured by the Russell 2000 Index underperformed large caps as measured by the S&P 500 Index by an average return of -5.2% during recessions (peak-to-trough). That data alone is not totally reassuring as far as timing an investment in small-caps.

However, when combined with additional analysis around the late and early stages of a bull market, the picture becomes clearer. There have been five recessions since 1980. During the 12 months prior to the peak, the Russell 2000 Index averaged returns of 37.9%, compared with 19.8% for the S&P 500 Index. During the 12 months after a trough, the Russell 2000 averaged a return of 75.8%, versus 45.4% for the S&P 500. The takeaway is that it has made sense to stick with small caps around recessions, despite the historical moderate underperformance during a downturn.

Mr Farrell adds “So there are numerous reasons to consider an appropriate allocation to the small cap universe — diversification benefits, inefficient markets and the sheer breadth of investment opportunities when compared to the large cap universe. History suggests investors should think twice about trying to time an investment in small-caps due to concerns about the economic cycle and the near-term outlook.”

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