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A Nationwide® White Paper
THE BENEFITS OF SMALL
CAPITALIZATION INVESTING
EXECUTIVE SUMMARY
• S
mall capitalization stocks have generally outperformed larger
peers over time.
• V
olatility of small cap stocks has exceeded large cap over time;
however, a diversified portfolio that includes both small and large
cap stocks can enhance the risk/return profile of a portfolio.
• A
ctive managers have outperformed the Russell 2000 over a
variety of time periods.
A Nationwide® White Paper
CHARACTERISTICS OF SMALL CAPITALIZATION INVESTMENTS
Companies with small capitalizations are generally earlier
in the life cycle, usually with faster earnings growth and
less diversified end markets than their large capitalization
peers. While there is no absolute characterization of what
constitutes a small capitalization name, one of the most
commonly used benchmarks to track the performance of
small cap stocks is the Russell 2000. The Russell 2000 is
comprised of the smallest 2000 names within the
broad-market Russell 3000, with the remainder
representing the large-cap Russell 1000. The Russell
3000 is weighted by market cap, and is therefore
dominated by the names in the Russell 1000. In fact, the
Russell 2000 accounts for only 8% of the weight of the
Russell 3000 with two-thirds of the constituents (Figure 1).
As Figure 2 shows, when compared with the Russell
1000, the Russell 2000 has faster earnings growth. This
isn’t surprising considering the more mature nature of the
larger peers’ business models and end markets. Smaller
%contributiontoRussell3000
%contributiontoRussell3000
Asof8/31/2016
Figure 1. % Contribution
to Russell 3000
Asof8/31/2016
8%
8%
Russell 2000
Russell 1000
Russell1000
Russell1000
Russell2000
Russell2000
companies also generally have a lower dividend yield,
higher price to earnings ratio, lower return on equity and
operating margin, and greater volatility, as measured by
beta. Also, given the greater degree of operating risk,
small companies carry less financial leverage, as measured
by debt-to-capital.
As Figure 3 illustrates, by sector, the Russell 2000 is more
exposed to the more economically cyclical and volatile
sectors, including Consumer Discretionary, Financials and
Industrials, and less exposed to the more mature and
capital intensive sectors, including Consumer Staples,
Energy and Telecom.
Many of these statistics suggest that the risk and
volatility experienced by small capitalization names
may be too great to warrant investment in the group,
particularly for more risk-averse investors. However, the
greater long-term performance and the diversification
benefit make small cap investments a valuable part of a
balanced investment allocation. Small caps have
unique characteristics that may help add to
performance, including the fact that they are less
followed by Wall Street Analysts (average company in
Russell 2000 followed by 5 analysts compared with 21
for Russell Top 200, according to HighMark Capital
Management). Also, valuation and price movements are
more often driven by company specific factors than
broad domestic and foreign macro trends, suggesting
opportunity for active managers.
92%
92%
Figure 3. Sector Weights of Russell 2000 and Russell 1000
As of 08/31/16. Source: Factset Research Systems Inc.
30.00
Figure 2. Weighted harmonic average (mutes the impact
of outliers)
Russell 1000
1.8
130.0
Estimated LT EPS Growth (Wgt Harm Avg)
12.0%
10.7%
Dividend Yield (Wgt Avg)
1.47%
1.98%
16.8
15.9
ROE (Wgt Avg)
11.0%
19.2%
Operating Margin
11.2%
20.4%
Projected Beta
1.19%
1.01%
Price to Forward EPS (Wgt Harm Avg)
20.00
Percent
Russell 2000
Market Capitalization ($b, Wgt Avg)
Russell 2000
R.2000 1000
R.1000
Russell
25.00
15.00
10.00
5.00
--
ConsDisc
ConsStaples
Energy
Financials
HealthCare
Industrials
Technology
Materials
Telecom
Utilities
SectorAllocation
As of 08/29/16. Source: FactSet Research Systems Inc.
As of 08/29/16. Source: FactSet Research Systems Inc.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
THE BENEFITS OF SMALL CAPITALIZATION INVESTING
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A Nationwide® White Paper
HISTORICAL PERFORMANCE OF SMALL CAP
While investing in small cap stocks has traditionally
delivered higher levels of return, it also has experienced
a greater degree of volatility. According to Kenneth
French data, dating back to 1927 through August of
2016, small capitalization stocks (as measured by the
smallest 30% of companies) returned 15.4% annually,
while the middle 40% returned 13.9% and the largest 30%
returned 11.0%. Figure 4 illustrates the consistency of that
outperformance, with the small cap group outperforming
the large cap group in 8 of the past 9 decades, often by
a substantial amount. During the current bull market,
small caps have outperformed large caps, as shown on
Figure 5. This was not, however, the case in 2015, when
the S&P 500 returned 1.4% compared with the S&P Small
Cap 600, which returned -2.0%.
The absolute level of volatility overstates the risk
when viewed in a portfolio context, considering the
diversification benefit. As Figure 6 illustrates, when all
publicly traded U.S. stocks are separated into quintiles
based on market capitalization, the largest quintile and
the smallest quintile are only 72% correlated with each
other, substantially lower than any other pairing of
quintiles. Therefore, while the absolute level of volatility
for smaller cap names is higher than large cap, when
combined into a portfolio, the low correlation creates a
diversification benefit.
Figure 5. Performance of small vs. large during current bull market
400
PerformanceofSmallvs.Largeduringcurrentbullmarket
350
Return(Indexedto 100on3/31/09)
Figure 4. Small vs. large by decade
Smallvs.largebydecade
1.8
1.4
1.2
1
250
200
150
100
Jun-16
Dec-15
Mar-16
Jun-15
Sep-15
Mar-15
Jun-14
Sep-14
Dec-14
Dec-13
Mar-14
Jun-13
Sep-13
Mar-13
Jun-12
Sep-12
Dec-12
Dec-11
S&P500
0.4
S&PSmallCap600
Source: Standard & Poor’s, Nationwide Economics
0.2
0
Mar-12
Jun-11
Sep-11
Mar-11
Jun-10
Sep-10
Dec-10
Dec-09
Mar-10
Jun-09
0
0.6
Sep-09
50
0.8
Mar-09
Average monthly return
1.6
300
1930s
1940s
1950s
1960s
1970s
Small
Large
1980s
As of 08/31/16, Source: Kenneth French Data, Nationwide Economics
1990s
2000s
2010s
Figure 6. Correlation of Monthly Returns by Market Capitalization
Quintile (11/1963 - 08/2016)
Smallest
Quintile
Smallest Quintile
Quintile 2
100%
Quintile
2
Quintile
3
Quintile
4
Largest
Quintile
92%
87%
82%
72%
100%
98%
94%
87%
Quintile 3
Quintile 4
Largest Quintile
100%
98%
92%
100%
96%
100%
Source: Kenneth French, CRSP
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
THE BENEFITS OF SMALL CAPITALIZATION INVESTING
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A Nationwide® White Paper
HISTORICAL PERFORMANCE OF SMALL CAP
When analyzing risk, it is important to understand how
small cap stocks perform in periods of stress. In this
regard, small caps have historically been less volatile
than suggested by analyzing volatility of return. Figure 7
shows how the Russell 2000 performed during the bear
market periods since 2000 (defined as a 20% decline
without a 20% rally). During the periods shown, the
Russell 2000 averaged a decline of 34%, only slightly
worse than the 33% decline of the Russell 1000. In bull
markets, however, the outperformance of the Russell
2000 is dramatic, averaging 135% return versus only 114%
for the Russell 1000 as described in Figure 8.
We believe active management has added value over time in the
small capitalization space. The combination of the large universe
of stocks, the lower level of attention from Wall Street analysts,
and the undiversified business models has resulted in a less
efficient market, which has allowed outperformance of active
managers versus the Russell 2000. As Figure 9 illustrates, more
than 50% of managers outperformed the index over a 5, 10 and
20-year horizon, with nearly two-thirds outperforming over the
past three years.
Figure 7. Performance vs. Bear Markets since 2000
20% correction without a 20% rally
Performanceversusbearmarketssince2000
Figure 9. Multi-Horizon Chart: Annualized Return
01/1994 to 12/2015
20%rallywithouta20%correction
0%
-5%
-10%
25
-15%
-20%
-25%
-30%
-27%
-35%
-40%
-33%
-33%
-36%
-34%
-36%
-36%
-45%
-50%
3/24/00-9/21/01
1/4/02-10/9/02
10/9/07-10/20/08
-33%
R1000
Russell 2000
R2000
Russell 1000
1/6/09-3/9/09
Total % return
20
15
10
5
0
-5
I Year
Source: FactSet Research Systems, Inc.
3 Year
5 Year
UNIVERSE
BOTTOM QUARTILE
Figure 8. Performance vs. Bull Markets since 2000
20% rally without a 20% correction
350%
20%rallywithouta20%correction
250%
10 Year
20 Year
QUARTILE 3
TOP PERFORMING QUARTILE
Sources: FactSet Research Systems, Inc.; Morningstar
Performanceversusbullmarketssince2000
300%
QUARTILE 2
7 Year
RUSSELL 2000 – TOTAL RETURN
281%
300%
R1000
Russell 2000
R2000
Russell 1000
200%
175%
150%
127%
100%
50%
0%
22%
32%
9/21/01-1/4/02
26%
10/9/02-10/9/07
34%
11/20/08-1/6/09
3/9/09-8/31/16*
* Current bullmarketstillinplaceasof12/31/14
* Current bull market is still in place since 12/31/14.
Source: Factset Research Systems, Inc.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
THE BENEFITS OF SMALL CAPITALIZATION INVESTING
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A Nationwide® White Paper
CONCLUSION
Small capitalization stocks have consistently
outperformed large caps over the long term, but in
2014 that trend reversed. Given the severity of the
performance gap, investors may be underweighted
small caps relative to their optimal allocation. Investors
should talk to their advisors about their allocation to
small caps. There are near term trends that support a
recovery in small caps, including the move in the dollar
and trends in the M&A market.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
Important Disclosures
This material is not a recommendation to buy, sell, hold, or rollover any asset, adopt an investment strategy, retain a specific
investment manager or use a particular account type. It does not take into account the specific investment objectives, tax and
financial condition or particular needs of any specific person. Investors should work with their financial professional to discuss their
specific situation.
Call 800-848-0920 to request a summary prospectus and/or a prospectus, or download prospectuses at nationwide.com/
mutualfunds. These prospectuses outline investment objectives, risks, fees, charges and expenses, and other information that you
should read and consider carefully before investing.
Principal Risks
Investing in mutual funds involves risk, including the possible loss of principal. Investors’ shares, when redeemed, may be worth
more or less than their original cost.
Investing in small cap stocks are subject to the risks of investing in equity securities (including small companies). Funds that
concentrate on specific sectors or smaller capitalization ranges may be subject to greater volatility than that of other mutual funds.
Index Definitions
Russell 1000®Index: An unmanaged index that measures the performance of the large-cap segment of the U.S. equity universe.
Russell 2000® Index: An unmanaged index that measures the performance of the small-capitalization segment of the U.S.
equity universe.
Russell 3000® Index: An unmanaged index that measures the performance of the 3,000 largest U.S. companies in the investable
U.S. equity universe.
Market index performance is provided by a third-party source Nationwide Funds Group deems to be reliable. Indexes are
unmanaged and have been provided for comparison purposes only. No fees or expenses have been reflected. Individuals cannot
invest directly in an index.
Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes.
The Fund is not sponsored, endorsed, or promoted by Russell, and Russell bears no liability with respect to any such funds or
securities or any index on which such funds or securities are based. Russell ® is a trademark of Russell Investment Group.
Nationwide Funds distributed by Nationwide Fund Distributors LLC (NFD), member FINRA, Columbus, OH. Nationwide Investment
Services Corporation, NISC.
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Company. © 2017 Nationwide
MFM-1253AO.6 (03/17)
THE BENEFITS OF SMALL CAPITALIZATION INVESTING
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