article 01-20-2017

More Volatility is Coming for Small-Caps (And That's Good)

Co-CIO Francis Gannon examines increased volatility among small-cap and large-cap stocks and explains why we would welcome higher levels.

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When good things are happening in the stock market, investors can be forgiven for forgetting about volatility.

Equities have enjoyed a remarkable run since the election—and were doing well leading up to it. This may have encouraged a pleasant bit of amnesia on the part of some investors that, as good contrarians who think constantly about market volatility, we would like to interrupt.

To be sure, a look at the VIX for both the small-cap Russell 2000 Index and large-cap S&P 500 over the last several years reveals some interesting developments.

First, small-cap volatility has been steady. After dipping to a rate of 17.1% of days when its VIX was at or above 20 in 2013, the last three years have seen a higher, and remarkably consistent, level of volatility.

For the three-year span covering 2014, 2015, and 2016, the number of days when the VIX hit 20 or higher was, respectively, 34.5%, 34.1%, and 34.5%.

As close as these years were in terms of the number of days at 20 or higher, we also observed between 2013 and 2016 a gradual uptick in the average level of the VIX, from 18.12 in 2013 to 20.05 in 2016. (2014 was at 19.42 and 2015 at 19.39.)

A Look at Small-Cap and Large-Cap Volatility

CBOE Russell 2000 Volatility Index (RVX) versus CBOE S&P 500 Volatility Index (VIX)

CBOE Russell 2000 Volatility Index and CBOE S&P 500 Volatility Index

The CBOE Russell 2000 Volatility Index (RVX) measures market expectations of near-term volatility conveyed by Russell 2000 stock index option prices. The CBOE S&P 500 Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

The very close levels of volatility for each of these three years, almost eerily uniform, is not necessarily the norm, and we would anticipate small-cap volatility moving higher in the years to come.

This would mirror what has already been happening in large-cap stocks, where the VIX spent the last two years at appreciably higher levels than the previous two.

Both small-cap and large-cap VIX indexes show more volatility in U.S. equities, with a dramatic move for large-cap from 2014 to 2015 (that held steady in 2016).

Small-cap's dramatic move occurred a year earlier and, while staying consistent in terms of the number of days, the level of volatility rose closer to its 10-year average, a trend we suspect will continue.

This is consistent with our observation that a more normalized economy and capital markets will mean, at times at least, more volatility.

As small-cap active managers, this suits us just fine. One of the ways in which we seek to manage risk is by embracing volatility and the opportunities it creates.

It is during those times when the market is struggling to make up its mind that stocks are often most attractively mispriced. And therein lies one of the keys to outperformance for active managers—the identification and purchase of mispriced securities.

Stay tuned…

Important Disclosure Information

Mr. Gannon's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The CBOE S&P 500 Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

The CBOE Russell 2000 Volatility Index (RVX) measures market expectations of near-term volatility conveyed by Russell 2000 stock index option prices.

The Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)

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