“Families are always rising and falling in America.” – Nathaniel Hawthorne, The House of Seven Gables
What Hawthorne said about American families can just as easily be applied to American companies. The table below contains snapshots of the top twelve holdings of the S&P 500 over the last several decades (note — data from Vanguard S&P 500 Index Fund -VFINX, often used as a proxy for S&P 500).
I’d like to interpret this table as evidence of the dynamic nature of the American economy. Joseph Schumpeter’s “creative destruction” is on display, as the young and hungry supplant the old and staid. Not only are some of today’s largest companies less than a decade or two old, they operate in industries that did not even exist 10–20 years ago. Contrast our economy with that of, say, France, where the youngest company in the CAC 40 Index was founded in 1967 (excluding mergers).
Of course, none of these companies started out on the top of the tables. Whether ten years old or a hundred years old, every large company started off as a small company. According to a recent piece in The Atlantic, Richard Foster of the Yale School of Management stated that the average lifespan of a company in the S&P 500 fell from 67 years in the 1920’s to just 15 years today. Moreover, Foster predicts that by 2027 nearly 75% of the companies in the S&P 500 today will be replaced by new firms.
Those with a long-term time horizon willing to invest with the up-and-coming segments of the economy have been rewarded. According to Morningstar/Ibbotson’s data, since 1925, small caps have averaged almost 2% more per year versus large caps. Academics have explored this “small cap premium” in great detail.
The downside, however, is that higher returns are coupled with higher risk. Many smaller companies will never become large companies, and many will die along the way. During periods of market turbulence, small caps tend to have higher volatilities and drawdowns than their large cap cousins.
With both the upside potential and downside risks in mind, Swan Global Investments has recently applied the Defined Risk Strategy to small cap stocks. Since 1997, Swan has successfully remained invested in large cap companies while mitigating the downside risks via the intelligent and efficient use of options. Conceptually, the Defined Risk Strategy can be applied to any asset class with an investable exchange traded fund (ETF) and liquid enough options on the ETF, whether S&P 500, emerging markets, foreign developed markets or others. Applying the DRS to other asset classes is explored in detail in the recent white paper “Diversifying with the Defined Risk Strategy.”
No one knows what companies or industries might be born, evolve, or dominate our economy over the next ten or twenty years. Twenty years ago most people wouldn’t have been able to conceive of social media, the iPhone or Amazon Prime, yet today many people couldn’t imagine life without them. With small cap stocks, investors have early exposure to the leaders of tomorrow.
See how the Defined Risk Strategy is applied to U.S. Small Cap stocks or for more information on the strategy contact Swan investment consultants.