Equities have taken big hits this year and small caps in particular have felt the crush of inflation and market uncertainty. The precipitous fall this year of small-cap stocks has led to strong investment opportunities for advisors looking to diversify their portfolios in a space that has several attractive qualities.
The Russell 2000, an index that tracks small-cap companies, is down 25% from its November peak last year. The index currently has a price-to-earnings ratio of 85.68 as of 11/25/2022 and is the only major equity index to have suffered exponential declines in its valuations this year — for reference, the p/e ratio a year ago was 715.75. The first half of this year has been the worst drawdown for the Russell 2000 since its inception in 1978.
The stocks that the Russell 2000 tracks are selling at deep discounts, not unsurprising given that small-cap companies tend to face greater challenges in times of economic downturns. That the valuations have declined this much is noteworthy. However, markets have already aggressively priced in recession risk, and given the unique positioning potential of small caps, there is potential opportunity within the space.
The Benefits of Increased Domestic Production
The Fed’s aggressive monetary tightening policy has sent the value of the U.S. dollar skyrocketing, taking a heavy toll on international currencies and multinational companies. Small caps have been fairly insulated from these currency shocks as they tend to be mainly focused domestically, and are positioned to benefit from more companies moving their production back to the U.S.
“Multinationals are onshoring their supply chain, and this should be a major tailwind for small-cap companies,” Nicholas Galluccio, portfolio manager at Teton Advisors which specializes in small-cap and microcap companies, told Barron’s.
The Small-Cap Bounce Back
Investing in small-caps can be a challenging sell when everything is sinking and the economy could be facing a potential recession. It’s important to note that historically small-caps tend to take the largest hits from investors before recessions, prove to be fairly resilient during recessions, and they almost always lead equities in recovery, bouncing back even before recessions have ended.
“Small-cap stocks, which tend to be more volatile and economically sensitive than large caps, typically sell off more in anticipation of an economic downturn. What may come as a surprise is that they also tend to recover before recessions end and lead the market coming out of a recession,” wrote Jonathan Coleman, CFA and portfolio manager at Janus Henderson Investors.
For advisors who don’t want to miss timing the recovery potential in small-caps or who want to capitalize on the deep discounts in small-caps right now but with risk-managed guardrails, the Nationwide Russell 2000 Risk-Managed Income ETF (NTKI) is an actively managed fund that utilizes an option collar in seeking to generate monthly income while reducing volatility and providing a measure of downside protection.
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KEY RISKS: The Nationwide Nasdaq-100® Risk-Managed Income ETF, Nationwide S&P 500® Risk-Managed Income ETF, Nationwide Dow Jones® Risk-Managed Income ETF, and Nationwide Russell 2000® Risk-Managed Income ETF (collectively, the “Risk-Managed Income ETFs”) are subject to the risks of investing in equity securities, including tracking stock (a class of common stock that “tracks” the performance of a unit or division within a larger company). A tracking stock’s value may decline even if the larger company’s stock increases in value. The Risk-Managed Income ETFs are subject to the risks of investing in foreign securities (currency fluctuations, political risks, differences in accounting and limited availability of information, all of which are magnified in emerging markets).
The Risk-Managed Income ETFs may invest in more-aggressive investments such as derivatives (which create investment leverage and illiquidity and are highly volatile). The Risk-Managed Income ETFs employ a collared options strategy (using call and put options is speculative and can lead to losses because of adverse movements in the price or value of the reference asset). The success of the Risk-Managed Income ETFs’ investment strategy may depend on the effectiveness of the subadviser’s quantitative tools for screening securities and on data provided by third parties. The Risk-Managed Income ETFs expect to invest a portion of their assets to replicate the holdings of an index. Correlation between Fund performance and index performance may be affected by Fund expenses and because the Fund may not be invested fully in the securities of the index or may hold securities not included in the index.
The Risk-Managed Income ETFs frequently may buy and sell portfolio securities and other assets to rebalance its exposure to various market sectors. Higher portfolio turnover may result in higher levels of transaction costs paid by the Risk-Managed Income ETFs and greater tax liabilities for shareholders. The Risk-Managed Income ETFs may concentrate on specific sectors or industries, subjecting them to greater volatility than that of other ETFs. The Risk-Managed Income ETFs may hold large positions in a small number of securities, and an increase or decrease in the value of such securities may have a disproportionate impact on the Funds’ value and total return. Although the Risk-Managed Income ETFs intend to invest in a variety of securities and instruments, the Risk-Managed Income ETFs will be considered non-diversified.
Additional risks include: Collared options strategy risk, correlation risk, derivatives risk, foreign investment risk, and industry concentration risk.
The Fund expects to invest a portion of its assets to replicate the holdings of an index. Correlation between Fund performance and index performance may be affected by Fund expenses and because the Fund may not be invested fully in the securities of the index or may hold securities not included in the index. The Fund frequently may buy and sell portfolio securities and other assets to rebalance its exposure to various market sectors. Higher portfolio turnover may result in higher levels of transaction costs paid by the Fund and greater tax liabilities for shareholders. The Fund may concentrate on specific sectors or industries, subjecting it to greater volatility than that of other ETFs. The Fund may hold large positions in a small number of securities, and an increase or decrease in the value of such securities may have a disproportionate impact on the Fund’s value and total return. Although the Fund intends to invest in a variety of securities and instruments, the Fund will be considered non-diversified. Additional Fund risk includes: Collared options strategy risk, correlation risk, derivatives risk, foreign investment risk, and industry concentration risk.
P/E Ratio – The price-to-earnings ratio is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
Russell 2000® Index: An unmanaged index that measures the performance of the small-capitalization segment of the U.S. equity universe.
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