The stock market is off to a rocky start in 2022. Some shares have fallen more than others: Exhibit 1 shows how small caps have lagged large caps in 2021 and into 2022, at least when measured using Russell indices. However, a deeper look shows a subset of small cap stocks drove much of this underperformance. Small companies with high stock prices that lose money or generate little profit may be holding back your small cap portfolio returns.

Exhibit 1
Small Returns
Growth of wealth, Russell 1000 vs. Russell 2000

Past performance is no guarantee of future results.

Performance includes reinvestment of dividends and other earnings. The growth of a dollar values represent the growth of wealth from December 31, 2020, through January 31, 2022. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

The top detractors to the Russell 2000 Index performance in 2021 share a common trait: they have low to negative profits and trade at high relative prices. At the beginning of 2021, each of the five companies charted in Exhibit 2 had generated negative profits over the previous year and traded at price-to-book ratios that placed them in the highest relative price quartile of the market.

Exhibit 2
Index Anchors
Top five detractors to the Russell 2000 Index return in 2021

Past performance is no guarantee of future results.

Returns are computed from Russell 2000 Index published security weights and Dimensional computed security returns. This information should not be considered a recommendation to buy or sell a particular security. Named securities may be held in accounts managed by Dimensional. The securities identified do not represent all securities purchased or sold for client accounts. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

Looking more broadly, we can see negative 2021 returns across many small caps with low profitability—particularly growth stocks with low profitability, as shown in Panels A and B of Exhibit 3.

Exhibit 3
Bubble Trouble
Panel A

Russell 2000 Index, market cap percentiles

Past performance is no guarantee of future results.

Holdings as of December 31, 2020
Stocks are plotted on price-to-book and profitability. The size of the bubble is proportional to the market capitalization of the stock. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Where book values are negative, stocks are plotted at the far left of the horizontal axis. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

However, looking broadly across decades of returns in global markets, we observe that small cap growth stocks with low profitability tend to underperform over the long run. And for good reason. From a valuation perspective, paying a lot for a company that earns little profit is a good sign of a very low discount rate, and therefore a low expected investor return. Research has shown that when examining stocks by their size, price-to-book, and profitability characteristics, small cap stocks with the lowest profitability and highest relative price have experienced the lowest historical returns.¹ By seeking to avoid these stocks, one can improve the expected return of a small cap portfolio returns. Commenting on the body of research examining these stocks, Professor Robert Novy-Marx said, “The small unprofitable growth portfolios are … way less than the sum of their parts. They just do so badly in the data.”²

Dimensional seeks to avoid these stocks in our portfolios that invest in small caps, such as those shown in Exhibit 4. And while this is not the only way our small cap funds may seek to add long-term value, 2021 adds another year to our long-run track record of delivering small cap solutions that have outperformed both peers and index funds.

Exhibit 4
Surviving and Thriving
One-and 10-year performance, as of December 31, 2021

Funds may have experienced negative performance over the time period. Past performance is no guarantee of future results.

Dimensional placement is the Morningstar 1- or 10-Year Total Return Absolute Category Rank sourced from Morningstar. Number of funds starting the 1- and 10-year periods is 665 and 581, respectively. The number of ranked investments for the 1- and 10-year periods is 630 and 352, respectively. The US Small Cap Portfolio placement in the 1- and 10-year periods is 70 and 90, respectively. The US Small Cap ETF placement in the 1- and 10-year periods is 41 and 68, respectively. The average index fund placement in the 1- and 10-year periods is 380 and 134, respectively. Number of funds starting the period is the number of share classes, within the respective Morningstar Category, with return histories as of the start of the 1- or 10-year period. The Morningstar category data is provided at the individual fund share class level. Multiple share classes of a fund typically have a common portfolio but impose different expense structures. The Average Index Fund Placement is the average, as determined by Dimensional, of the Morningstar 1- or 10-Year Total Return Absolute Category Rank for index funds within the respective Morningstar category. All funds are US-domiciled.

Prior to listing on June 14, 2021, the ETF operated as a mutual fund. The NAVs of the predecessor mutual fund are used for both NAV and market price performance from inception to listing. The market price return is calculated from closing prices as determined by the fund’s listing exchange. If you trade your shares at another time, your return may differ. Performance includes reinvestment of dividends and other earnings.

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