[Herald Interview] Small-cap index can ‘reduce risk’ as long as qualities are checked

In February this year, the Korea Exchange, South Korea’s market operator and stock index developer, birthed the KRX 300 benchmark index that represents the tiered stock market in Korea.

The KRX unveiled the mid-cap index called KRX Mid 200 in June, comprising constituents from the top-tier Kospi and second-tier Kosdaq, and released plans for another index for small caps in the near future. The moves aimed to balance institutional influx into tiered stock markets in Korea and enable investors’ size rotation.

But after the KRX Mid 200 underperformed against large cap indexes including the KRX 300 and Kospi 200 so far, the KRX appears to be at a crossroads in carrying out the follow-up launch of the index of smaller companies.

However, Jodie Gunzberg, managing director and head of US equities at US index manager S&P Dow Jones Indices, stresses that the small-cap index as a whole could reduce the risk because it pursues diversification by itself.

What matters in evaluating the performance of a small-cap index is rather the methodology that ensures the index’s buffer from risk than yields of the index, Gunzberg said.

Instead of flatly opining about Korean indexes, Gunzberg brought up the benchmark S&P SmallCap 600 as an example in an interview with The Korea Herald.

From January this year until Thursday, the S&P SmallCap 600 has beaten S&P DJI’s other benchmarks, including the broad-based S&P 500 and S&P MidCap 400 in terms of returns.

While the S&P 600 yielded 13.1 percent return from January, the S&P 500 and S&P 400 yielded 4.9 percent and 5.7 percent, respectively. 

These yields came in contrast to the Korean stock market. The KRX Mid 200 dipped 4.1 percent since its June launch through Friday closing, while the KRX 300 and Kospi 200 -- Korea‘s leading benchmark index -- slipped 2.5 percent and 2.2 percent over the cited period, respectively. Since Feb. 5, when the KRX 300 was launched, the KRX Mid 200 has sunk 16 percent, while the KRX 300 and Kospi 200 were 9 percent and 9.2 percent lower, respectively.

“(Small-cap indexes) can actually reduce risk because the contribution to returns don’t rely so heavily on one stock or because the sectors are a little more well-diversified,” she said.

“There’s more diversification across sectors in small caps and less concentration by the top 10 holdings in small caps.”

To achieve “small-cap premium” through the index, however, a toughened screening criteria for index constituents is needed to make index-tracking instruments more investable.

“There’s a small cap premium that investors get paid for taking the risk to invest in small caps rather than large caps,” she said. “In order to capture that premium, you need quality.”

Currently, constituents of both the KRX 300 and KRX Mid 200 are decided under the same set of criteria -- market cap, liquidity measured through trade volume and current ratio and zero impaired loans. The KRX regularly changes constituents twice a year.

Gunzberg said one more screening criterion could make a difference: earnings screening.

In the case of the S&P SmallCap 600, to be eligible a firm has to record profit in the most current quarter and the sum of the last four quarters. The evaluation of earnings, alongside liquidities, is critical for “passive quantitative rules-based methodology,” according to Gunzberg.

“Without those earnings, you don’t get those returns,” she said. “What we’re trying to educate about is that rather than paying active management (fees) for small cap, small cap can be passive and very competitive with a very simple index construction.”

Other upsides, particularly for the S&P SmallCap 600, are macroeconomic factors such as rising interest rates, inflation and growing gross domestic product in the US, Gunzberg added.

By Son Ji-hyoung 
(consnow@heraldcorp.com)