Chasing Performance and Knowing When to Leave

NEW YORK (TheStreet) -- There is no doubt the last five years have been good to stock investors as the bull market has reached new heights of exuberance. Whether you believe that the rally is Federal Reserve-stimulated or a true reflection of economic prosperity is a hotly contested argument that will rage on for years to come.

The unquestionable leaders on the upside have been small-cap and high-beta stocks that have soared during this period of low interest rates, fiscal stimulus and economic recovery. At the other end of the spectrum are large- and mega-cap stocks that have been slower to keep pace with performance hungry investors. This has created a dichotomy between performance and valuations among these two groups that may be subject to change if we see additional volatility and rotation take hold this year.

The average annual gains over the last five years for the SPDR S&P 500 ETF (SPY) and SPDR Dow Jones Industrial Average ETF (DIA) are listed at 22.78% and 21.20%, respectively, through Feb. 28. By contrast, the iShares Russell 200 ETF (IWM) has gained 26.60% over that same time frame.

This level of outperformance has led to momentum chasing by investors that has helped boost the current P/E ratio of the Russell 2000 Index to 83.69 versus 17.97 for the S&P 500 Index. Clearly investors are more exuberant for risk than fundamental data is supportive of such lofty price levels. However, at the end of the day price is the ultimate arbiter of reality, not valuations.

The wide divergence between these two data points may ultimately lead to a future period of underperformance by small-caps as investors see more value in large cap names. A period of slow growth or declining stock prices may ultimately lead to larger companies taking center stage in the next phase of beta rotation. Remember that DIA was one of the best-performing major market indices back in 2011 when we experienced our last true bout of stock volatility.

One of the beneficiaries of this small cap boom has been smart-beta exchange-traded funds that are designed to select a subset of stocks in a given sector by fundamental and momentum-based criteria. What you are left with is a unique portfolio of large, mid, and small-cap names that have generally outperformed traditional market-cap weighted indexes over the last five years.

One example of this index methodology is the First Trust Healthcare AlphaDex Fund (FXH), which contains 74 underlying holdings in the healthcare sector and has nearly $2 billion under management. The ETF has outperformed the Healthcare Select Sector SPDR (XLV) over the last one, three and five years with vastly different underlying holdings that slant towards smaller companies. FXH and similar smart-beta ETFs have worked well during this rally, but may come under fire if we start to see small-cap stocks lose their momentum or churn sideways.

There is certainly more room on the upside for the markets to run and they have shown a remarkable resilience to ignore valuation models for years. That being said, when we do see a true change in market conditions, I would expect small-cap stocks will be the most vulnerable to downside risk. There will still be pockets of value that emerge, but you will have to be more selective about the areas that you place your money.

Fortunately, ETF providers also offer low volatility funds such as the iShares MSCI USA Minimum Volatility ETF (USMV) and the PowerShares S&P 500 Low Volatility Portfolio (SPLV) as suitable alternatives.

These ETFs focus on a subset of stocks that with fewer price fluctuations than their fully-loaded index peers. I would expect that they will have better relative performance than small cap stocks in a deflationary or choppy market environment.

At the time of publication the author had a position in USMV.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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