2 Reasons Why S Fund Underperforming C Fund

2 Reasons Why S Fund Underperforming C Fund | Smaller company stocks (S Fund) tend to perform better in the early phase of an economic expansion. While large company stocks (C Fund) tend to perform better in the later stages of an economic expansion. When growth is slowing but profits are still high.

Last week was the U.S. stock market’s worst week of 2019, although that is a pretty low bar considering that it has been a very strong calendar year so far. The S&P 500, which the C Fund tracks, dipped by approximately 3% last week. The week started off flat, but two catalysts caused selloffs later in the week.

The first catalyst was on Wednesday when the Federal Reserve announced a 0.25% cut to key interest rates. The market expected this, but later in the day the Fed’s chairman Jerome Powell argued that it was likely a mid-cycle cut rather than the beginning of a multi-cut cycle. This language was slightly more hawkish than the market expected and the stock market took a sudden dip.

The second catalyst was on Thursday afternoon when President Trump tweeted that the United States would put 10% tariffs on the $300 billion in Chinese imports that are not currently subject to tariffs, which is in addition to the 25% tariffs currently imposed on $250 billion worth of Chinese imports. This reignited investor uncertainty regarding ongoing trade negotiations at a time when global economic growth is slowing down.

C Fund vs S Fund

Over the past 12 months, the smaller-company S Fund has underperformed the larger-company C Fund by a cumulative 7.37%. The C Fund is up 5.82% while the S Fund is down -1.55%:

Chart Source: FEDweek

The S Fund is also underperforming the C Fund over the past 3-year and 5-year periods. The two funds are roughly matched over the past 10-year period, and the S Fund is outperforming over the past 15-year period.

While the reasons for an index to underperform any other index over a given period are myriad and sometimes unknowable, there are a couple of clear differences between the C Fund and the S Fund that appear to be driving recent underperformance for the S Fund.

Sector Differences

The C Fund tracks the S&P 500 index, which consists of the largest 500 publicly traded companies in the United States. The S Fund tracks the Dow Jones U.S. Completion Total Stock Market Index, which consists of over 3,000 smaller companies that make up most of the rest of the stock market in the United States. Which is not included in the S&P 500.

The C Fund’s two biggest sectors are Information Technology (21.8%) and Healthcare (13.8%):

Chart Source: S&P Dow Jones Indices

Meanwhile, the S Fund’s two largest sectors are currently Financials (25.6%) and Industrials (17.9%):

Chart Source: S&P Dow Jones Indices

Smaller banks in the United States are currently being squeezed by a flattening yield curve and low-interest rates in general. Industrials are under pressure from the declining global manufacturing purchasing manager’s index (PMI). Which shows cyclical expansions and contractions within the global manufacturing sector:

Chart: J.P. Morgan and IHS Markit

Overall, these sector differences can create environments where large companies outperform small companies, or small companies outperform large companies. Right now, smaller companies are the ones facing more pressure.

Profitability Differences

Approximately 30-40% of small-cap companies in the S Fund are unprofitable in any given year. While most large companies within the C Fund are profitable. This means that smaller companies are more reliant on external funding from banks or bond investors, and their credit scores are often weaker. This means they borrow at a higher interest rate than large blue-chip companies.

Additionally, smaller-company stocks generally benefit less from share buybacks than large, profitable companies. Over the past year, tax cuts and cash repatriation have been catalysts for record-high levels of buybacks among the S&P 500 companies. So that even as their top-line growth may be sluggish, their per-share growth can still be solid.

Smaller companies, on the other hand, especially unprofitable ones, are more reliant on topline growth to perform well. And do not partake in share buybacks to boost per-share data to the same extent that large companies do. As a consequence, smaller-company stocks historically tend to perform better in the early phase of an economic expansion when growth is reigniting. While large-company stocks tend to perform better in the later stages of an economic expansion. When growth is slowing but profits are still high, which allows for large spending on share buybacks.

To see the full article written by Lyn Alden and published in FedWeek Magazine, click here.