After a gaudy three month move up on the part of small cap stocks, it's time for a change in investment strategy. Good-bye passive investing. Hello, active management.
"In this environment, I think active management will outperform passive funds," said Arturo Neto, founder of Orenda Partners, a Coral Gables, Fla., provider of investment strategy and research services to small and mid-sized investment advisory firms.
Part of the expectation is simply market dynamics. Small cap stocks have had a feverish move during the so-called Trump rally, with the Russell 2000 Index, the most widely quoted small cap barometer, posting gains of as much as 22%. That's double what the broad market achieved. The rally has proven so powerful - and, because it was largely based on a "lift all boats" surge on the part of indexes - that some active managers admit that it's tough to find value in this market, and have gone to higher than normal cash levels.
Others, though, are more dogged.
"If I can't find something cheap and good in the small cap world, I'm not working hard enough," said Matt Finn, portfolio manager at Thrivent Financial in Minneapolis, and the manager of the firm's Thrivent Small Cap Stock Fund.
The Thrivent small cap fund is virtually fully invested. Financials, industrials and information technology comprise more than half the fund's investments, which include holdings in Nutrisystem (NTRI) , Synovus Financial (SNV) and Janus Capital (JNS) .
Financials have the largest sector weighting among most small cap indicators, such as the Russell 2000. But in an environment in which rates are expected to rise and regulatory burdens on banking institutions are expected to lighten, wouldn't investors want to further over emphasize their exposure to the sector?
"I would stay away from funds that are limited in the amount they can allocate to individual companies or sectors based on comparisons to a benchmark, and find the funds that allow the manager more flexibility to invest with conviction," Neto said.
"Correlations have different effects on different industries," according to Mark Spatt, an investment analyst at Cornerstone Investment Partners, which sub-advises on the AdvisorShares Cornerstone Small Cap ETF (SCAP) . The ETF has a 25% exposure to technology, 16% to industrials and 11% to financials, and among its top holdings are chip maker Inphi (IPHI) and airline SkyWest (SKYW) .
Small cap names in industrials and consumer discretionary sectors are expected to benefit from promises President Trump made both during the presidential election campaign and in the months leading up to his inauguration, including a domestically oriented agenda, increased spending on infrastructure and reduced corporate taxes.
"The high quality companies we own are consistently profitable and will clearly benefit from reduced corporate tax rates," Steven Scruggs, portfolio manager at the Queens Road Small Cap Value Fund (QRSVX) , said in a recent interview. (The QRSVX is the highest rated small cap fund in The Street's analysis of fund products.)
The Queens Road small cap fund is heavily skewed toward industrials, which comprise nearly one third of the portfolio, as well as technology, consumer cyclical and financials, which together make up more than half. Among its largest holdings are the Texas bank Hilltop Holdings (HTH) and Orbital ATK (OA) , the defense contractor that figures to be another sector that should benefit from the Trump administration agenda.