We often are asked what the right size and style box is for our U.S. portfolio. From a style perspective we are clearly deep on the value side of the spectrum. Less clear is where we fit from a size perspective.

As of year-end 2022*, the average market capitalization of our capitalization-scaled (LAM-CS) portfolio construction was $37 billion. This appears significantly smaller than the $234 billion of the S&P 500 Value index or the $151 billion of the S&P 900 Value index. On the other hand, it is significantly larger than the $5.8 billion of the S&P Midcap 400 Value index. So, where should investors place Lyrical? Large Value or Mid Value?

For nearly all our clients, they place us in the large-cap value box, mainly because our portfolio closely resembles the constituents of the S&P 500 Value and S&P 900 Value, once you eliminate the gross distortion of cap weighting.

CAPITALIZATION WEIGHTING DISTORTION

S&P capitalization weights their indices, meaning the larger the market cap, the larger the weight in the index. This causes the average market cap of the S&P 500 Value and S&P 900 Value indices to be a grossly distorted picture of their constituents.

In the stock market, the distribution of market caps follows what is known in mathematics as a “power law.” The largest stock in the market has a gigantic market cap, and it falls rapidly as you move to the second, third, fourth largest stocks, etc. Quickly, the curve flattens as the pace of decline dramatically levels off. Below is a chart of the top 100 stocks by market cap in the U.S. market at year-end 2022.

LYRICAL LOOKS LIKE LARGE CAP

Looking at Lyrical’s portfolio, it is clear to us that large cap is the most appropriate category. While we appear to be much smaller than the cap weighted averages of the S&P 500 and S&P 900 Value indices, we are very much in-line with the equal weighted average of these same indices. Our LAM-CS composite has an average market cap of $37.5 billion, right between the $55.5 and $34.9 billion of an equal-weighted S&P 500 Value and S&P 900 Value.

Source: FactSet

 

Given our average cap is much lower than the cap-weighted indices, some question whether we belong in the mid-cap category. As you can see on the chart above, we don’t fit mid-cap very well, as it is dramatically smaller than our average cap. In fact, our average market cap is more than sixfold bigger than the $5.8 billion of the S&P Midcap 400 Value.

A DISTINCTION WITHOUT A DIFFERENCE

The debate about S&P 500 Value versus S&P 900 Value, or large-cap versus mid-cap is mostly about distinctions without a difference. When institutional investors allocate to a style box, they want to make sure they are getting the characteristics of that style. While the average market caps change dramatically from S&P 500 to S&P 900, or from cap weighting to equal weighting, the performance characteristics do not change much.

Firstly, the S&P 500 Value and S&P 900 Value have basically the same return stream. Since Lyrical’s inception in 2009, the returns of the S&P 500 Value have correlated 99.97% to the S&P 900 Value.

Moving from cap-weighting to equal-weighting makes a slightly bigger difference, but that difference is still small. Since 2009, the returns of the cap-weighted S&P 500 Value have correlated 98.5% with an equal-weighted S&P 500 Value, and the returns of the cap-weighted S&P 900 Value have correlated 96.0% with an equal-weighted S&P 900 Value. These are all very high correlations.

Lastly, even the difference between the cap-weighted large-cap and mid-cap is not that different. Since 2009, the returns of the S&P 500 Value and S&P Midcap 400 Value have been 95.7% correlated. Again, very high correlation.

THERE IS ONE KEY DIFFERENCE: RETURNS

While the correlations between the standard indices, their equal-weighted versions, and their mid-cap relatives have been very high, the returns themselves have been materially different. Historically, the value stocks with the largest market caps have been underperformers, making the cap-weighted large-cap value indices the worst performing indices of this group.

In the chart below we present, for of all the indices we have referenced, the returns over Lyrical’s history of 2009 through 2022. The two worst performing indices in this chart are the cap-weighted S&P 500 Value and S&P 900 Value.

Interestingly, these indices did not pick the wrong stocks, just the wrong weights. The two best performing indices are the equal-weighted versions of those same indices! Equal weighting improved the returns of the S&P 500 Value by 180 bps per annum, and the S&P 900 Value by 150 bps per annum.

This was not a “small-cap” effect, as you can see these equal-weighted large-cap indices outperformed the smaller cap indices of the S&P MidCap 400 Value and S&P SmallCap 600 Value.

Source: FactSet

CONCLUSION

Once you look past the gross distortions of market-cap weighting, it becomes clearer that Lyrical best fits in the large-cap value category. Our true best fit would be for equal-weight large cap value, though we have never actually met anyone that uses that classification. While not as good a fit, some clients have used us for mid-cap or all-cap mandates. Given the high correlation between large-cap and mid-cap, this is not a bad fit, even as our market-cap profile is significantly larger than that of the mid-cap benchmark.

We also have been used as a satellite manager in a core-satellite approach, and some clients have placed us in special buckets they have for differentiated high active share or opportunistic strategies.

The question of large-cap or mid-cap arises because we have a lower average market cap than the cap-weighted large-cap indices, but if you know where the better returns have been, this has clearly been an advantage, not a drawback.

There is also the issue of correlation and tracking error. Given the high correlation between the cap-weighted large cap indices and their equal-weighted versions, or even their mid-cap counterparts, portfolio average market cap should not be a concern. However, at Lyrical we construct concentrated portfolios with very high active share. Whatever our average market cap, we are going to have high tracking error relative to these benchmarks. Again, we think this is an advantage, not a drawback. If you want these indices, they are available through cheap passive options. But if you are looking to outperform these indices, that is not going to happen without a portfolio that looks markedly different than those indices.