Strategies for Minimizing Risk in Small-Scale Capital Investments
The small-cap market, while offering promising growth potential, is known for its volatility. But fear not, for there are strategies that can help investors navigate this space with more confidence.
Firstly, many active small-cap strategies already incorporate a blend of technical and fundamental approaches. This combination allows for a more balanced approach to portfolio management. For instance, an investor might start by screening for a quality basket of small caps using fundamental checks and then use moving average crossovers as a risk-on or risk-off signal for entry and exit timing.
The S&P SmallCap 600 Index, a popular benchmark for small-cap stocks, requires companies to have posted positive earnings in the most recent quarter and over the past four consecutive quarters. This basic earnings check is a good starting point for any small-cap investment strategy. However, active managers can apply more tailored and rigorous filters, such as positive free cash flow, high return on equity, dividend consistency, and net share buybacks, to further refine their selection. These additional quality screens can help ensure small-cap exposure tilts toward companies better equipped to handle market turbulence.
A practical strategy to reduce the risk of investing in small caps is using technical indicators such as moving average crossovers. An investor might enter a long position in small caps when the 50-day SMA crosses above the 200-day SMA, and exit to cash when the 50-day drops below the 200-day. However, it's important to note that moving average crossovers can lead to false signals, known as "whipsaws," especially in sideways markets.
Seasoned small-cap investors may embrace volatility to deploy strategies like buy-write (covered call) approaches to harvest income from premium. This kind of rotation strategy can help limit drawdowns during extended downtrends.
In the small-cap space, it's easy for low-quality "junk" companies with negative earnings and weak balance sheets to find their way into passive indices. To temper small-cap volatility, it's beneficial to focus on quality by investing in companies with strong fundamentals: consistent earnings, manageable debt, and efficient operations.
Active asset managers that theoretically combine both technical and fundamental strategies to reduce risk in small-cap market products include Nordstern Kapitalmanagement, Minveo, and Sphere Swiss. These firms use a variety of methods, from fundamental macroanalysis and technical trading signals to AI-driven algorithms and structured multi-asset approaches, to control risk and maximise returns.
Historically, the S&P SmallCap 600 Index has translated into significantly stronger long-term returns than the Russell 2000. So, while the day-to-day swings may be a deterrent for some long-term, buy-and-hold investors, the potential rewards make the small-cap market an attractive investment opportunity.
