How To Build A More Complete Quality Portfolio In U.S. Equities


In 2015, Cliff Asness and his colleagues released a paper with the highly provocative title “Size Matters, if You Control Your Junk.”1

We agree that taking an additional layer of focus within small-cap stocks—for example, small caps plus quality, small caps plus value or small caps plus momentum—can be very helpful, to allow for the risk/return trade-offs to be potentially more attractive.

However, it is critical to think of small caps not only as stand-alone options but also in terms of how they might sit within portfolio allocations.

Quantifying a Quality Upgrade over the Long Term

Small Cap Blending Cumulative Growth

Large Caps and Small Caps vs. Large Quality and Small Quality

Factor investing has generated significant attention of late:

  • Blending Large Caps and Small Caps Outperformed the Market: Over this very long period, going from a full, broad market strategy to a strategy of 70% large caps and 30% small caps outperformed by more than 60 basis points (bps) per year. However, this did also come with an incremental increase in about 60 bps of risk, leading to a slightly higher Sharpe ratio.
  • Practical Application of the Factor Discussion—the “Quality Upgrade”: Much has been made of the various investment factors, but we think one of the primary potential benefits lies in introducing tilts to a given exposure. Here, we looked at the concept of 70% large-cap quality and 30% small-cap quality, instead of merely saying 70% large cap and 30% small cap. As can be seen, there was a greater than 2%-per-year incremental increase in returns, leading to a terminal growth of $1,000 that is more than twice as high as simply looking at the large-cap/small-cap blend alone. This was also achieved with a much more significant increase in the Sharpe ratio.
  • Small Caps Offer Fertile Ground for Factor Tilts

    While the five commonly discussed factor exposures are value, momentum, quality, size and low volatility, we’d encourage investors to not think of them as necessarily being mutually exclusive. For instance, the concept of small value has been prevalent for many years and would imply exposure to at least two factor premiums—small caps and value. 

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