FTSE Russell Insights

Time to Target a Quality Exposure in Small Cap Equities?

Ryan Giannotto

Manager, Equity Index Research

It is a truth universally acknowledged that a $2 billion company will be more in want of liquidity than a $200 billion company. As the lag effects of rate hikes become clearly manifest, investors allocating to small caps are uniquely sensitive to this tougher new market regime.

The Russell 2000 Index bears testament to this: it carries five times the negative earnings exposure as its large cap counterpart, along with higher relative debt burdens. But rather than forego small caps altogether, we have found that leaning to quality can ameliorate these negative risk factors while preserving the uniqueness of a small cap strategy. Here we explore how the Target Exposure methodology creates a smooth and consistent quality risk profile in small caps, and how this strategy materializes in terms of performance and portfolio fundamentals.

A Quality Build

While some factors are relatively straightforward in construction, in particular value, quality has been more broadly interpreted by investment strategists. At FTSE Russell, we contend that quality is a dualistic factor, composed of a company’s leverage and profitability. Intuitively, this rationale is sensible, as a high-quality company is one that can maintain healthy margins and a responsible debt load, especially in a declining market. The recent bank failures provide an excellent test case for this premise, with the Russell 2000 Target Exposure Quality Index outperforming its benchmark by 1.02% through the ensuing tumult, gaining 7.3 basis points per day.

Stress Test Quality Outperforms Under Pressure

This chart displays how companies are evaluated by their cash flow coverage ratios, an ideal metric to determine a company’s ability to service their debt load. Notably this value is capped at 1.0, to prevent stocks with little to no debt from breaking the curve.

The Russell 2000 Target Exposure Quality Index outperformed its benchmark by 102 basis points since the beginning of U.S. bank runs Thursday March 9th. Source: FTSE Russell data. Past performance is no guarantee of future results.

For assessing leverage, companies are evaluated by their cash flow coverage ratios, an ideal metric to determine a company’s ability to service their debt load. Notably this value is capped at 1.0, to prevent stocks with little to no debt from breaking the curve—consider how a company with $1 of debt on its balance sheet, and any cash flows at all, would otherwise have a near infinitely perfect leverage score.

In the case of profitability, we find a three sub-factor approach to be the most robust means of assessment, as there are a variety of mechanisms for revenue and margin quality to either degrade or be papered over in the short term. Hence, we analyze first a company’s return on assets (ROA), second the rate of change in asset turnover, and third, a company’s accruals (taken in the negative, as high accruals are an indicator deteriorating profitability into the future).

Each of these three-profitability metrics and the single leverage measure are evaluated by z-score, meaning we calculate how many standard deviations from the mean companies fall on these criteria. Moreover, these values are limited to a range of plus or minus three to dampen the impact of outliers. To arrive at a combined quality score, the profitability z-scores are averaged to form a composite profitability value, which is in turn averaged with the leverage score for to achieve the overall quality z-score. Finally, these values are renormalized via the exponential function, so all figures are positive. The end result is that all stocks receive a comprehensive S-Score on quality on a scale of near zero to roughly twenty.

Target (Exposure) Acquired!

How are these quality factor scores translated into a holistic portfolio? That is the mission set of the Target Exposure methodology, which is fundamentally a tilting framework. Conceptually, the process is analogous to portfolio liposuction—we remove weight from low-quality stocks we don’t want, and graft this freed-up allocation space to the high quality stocks we do want. Mathematically, this result is achieved by taking the benchmark weights and multiplying in proportion to the S-Score; stocks with high-quality scores will receive large active weights, those with average scores will remain at market cap weight, and those with low scores will be reduced or even eliminated outright. Additionally, at each rebalance the level of tilt into quality is recalibrated for a steady level of risk exposure, and unwanted factor loads are neutralized as well.

Table 1: The Quality Scoreboard

Metric R2000 R2000 Quality TE Metric Increase
Coverage 0.06 0.45 594%
ROA 0.94% 6.83% 628%
Accruals 7.60% 6.62% -12.8%
Turnover 5.66% 6.04% 6.6%

Source: FTSE Russell, data as of 15 March 2023. Past performance is no guarantee of future results.

The advantage of this approach is that the portfolio can gain a significant quality exposure while maintaining fidelity to the original Russell 2000 Index. Indeed, the Target Exposure Quality strategy carries a 45% active share to the parent Russell 2000 Index while sustaining a correlation of 0.998, all while achieving substantial gains in portfolio quality fundamentals. The roughly seven-fold increases to debt coverage and ROA stem from how the small cap ecosystem sees a very high concentration of “junk” companies—those with negative earnings, speculative business models, or formerly successful companies that succumbed to financial distress.

Russell 2000 Quality vs. Russell 2000 in Bear Markets

This chart shows how the five bear markets in the Russell 3000 Index since 2000, the Russell 2000 Quality Target Index outperformed its benchmark by 2.37% on average during the downdraws.  While some of this outperformance is returned during the recovery cycle (avg. 0.42%), on a combined basis the quality tilt extends its gains to 3.41% due to compounding in up markets.

The Russell 2000 Quality Target Exposure Index outperformance relative to the Russell 2000 Index in the five bear markets in the Russell 3000 Index since 2000, as defined by a 20% or greater drawdown. 2022 recovery truncated at 3/15/2023. Source: FTSE Russell Data.. Past performance is guarantee of future results.

That the small cap universe lends itself to a quality tilt is born out on a performance basis as well. Through the five bear markets in the Russell 3000 Index since 2000, the Russell 2000 Quality Target Index outperformed its benchmark by 2.37% on average during the downdraws. While some of this outperformance is returned during the recovery cycle (avg. 0.42%), on a combined basis the quality tilt extends its gains to 3.41% due to compounding in up markets. 

Quality exhibited more tepid performance benefits during the 2018 and Covid bear markets, as interest rates were low, and indebtedness was less acute of a market factor. Considering the aggressiveness in interest rate hikes and the receding of market liquidity, tilting to quality may once more commend itself in seeking a more robust small cap risk profile.

For more information on the Russell 2000 Quality Target Index, watch our recent webinar with Legal and General Investment Management.

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