Dec. 2, 2021

Coping with concentration
in small caps

Guest: Peter Crivelli, Senior Vice President at Carillon Tower Advisers

In this episode of Markets in Focus

Concentration in the small-cap indices is presenting challenges for investors and active managers. Peter Crivelli, Senior Vice President at Carillon Tower Advisers, joins Matt Orton, CFA, Carillon’s Chief Market Strategist, to navigate opportunity in the sectors taking up the most space.

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Matt Orton:
There have been some very big changes to the broader U.S. equity market over the past decade. Perhaps one of the most apparent and most discussed is the rise of information technology and the dominance of mega cap technology. IT makes up nearly 30% of the Russell 1000 Index, and if you look at the Russell 1000 Growth Index, that increases all the way to 44.5%. And the big five represent more than 35% of that. That's right, five stocks make up more than 35% of that total index. That is huge growth and it's in a very select part of the market. And that also is what I consider to be meaningful concentration. However, the increase in concentration has also occurred down the market cap spectrum, notably in small caps. And the growth in concentration within small-cap indices has led to some meaningful distortions in performance, both of the index and for active managers.

Today, I'm joined by Peter Crivelli, Senior Vice President at Carillon Tower Advisers, who hears nearly every day from institutional consultants about their thoughts on the market, asset allocation, and the performance of active managers. We're going to change things up a little bit today, and this time around, I'm going to let Peter take over the hosting duties and I'm going to sit in the hot seat to answer his questions. This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at for additional episodes and insights. All right, Peter, are you ready to kick things off?

Peter Crivelli:
I am, Matt. And thank you. I'm glad to have you on the hot seat, and I'm glad you're willing to share your thoughts with our listeners. As you just said, we've seen increased concentration in large caps, especially in those largest IT companies. It seems like this has occurred pretty quickly. Maybe you can lay out how we got there and what you've seen managers doing to address this as a result.

Matt Orton:
Yeah, absolutely. And really, the spike in mega cap technology has occurred over the past few years, but the increase in information technology, and I would say the other growthier sectors, like consumer discretionary and communication services, that has been a much more gradual process that has been taking place really since the end of the financial crisis in 2008, 2009. We've seen, I'd say the more value parts of the market, decrease from about 50%, down to less than 30% of the S&P 500 today, while growth has seen really the opposite. It's increased from around 30% and now makes up over 50% of the market. That's been a pretty gradual process over the past 10, 11 years, but the spike that we've seen in mega-cap technology dominating the indices, that's been a much more recent phenomenon that really started with the massive out-performance of I'd say the highest duration assets, really big growth companies over the past three to four years.

We've seen it happen with a number of big names. I'd say the most recent example of which is Tesla. It's become a ubiquitous part of the market and now makes up a much larger part of the overall benchmark. What's noticeable Peter that I'll point out is that active managers have struggled in the large-cap space, and it's been largely due to the dominance of these names. It's important to know that the change towards growth has been gradual, but the increase in concentration, specifically towards a handful of names at the top, that has been much more recent.

Peter Crivelli:
Thanks, Matt. I appreciate you setting the stage with talking about large capitalization stocks. But concentration in small caps has also been a factor. Can you highlight the increase in concentration in small caps?

Matt Orton:
Yeah, and that's a great point Peter, that there is concentration in small caps and it really doesn't receive as much attention as the changes that we've seen up market cap. But it's been pretty dramatic, the changes that we've seen in small caps. If I start with small-cap value, the financial sector makes up over 26% of the Russell 2000 Value Index, and the next largest sector is over 12% smaller than that. So you can see there's a meaningful concentration towards the financials. And if we flip to the growth side, concentration is even more prevalent, notably in healthcare. Healthcare makes up nearly 30% of the Russell 2000 Growth. Information technology also makes up a pretty big weight at 22%. So you've got two sectors in the Russell 2000 Growth Index that make up over 50% of the benchmark weight. And the concentration is evident also at the industry level, so it's not just at the sector level.

If we go to the small-cap value again, within the Russell 2000 Value Index, banks make up 15% of small cap values while REITs take up 11%. So you can see very meaningful concentration at the industry level. If you look at the growth side, this is probably where there's some similar extreme examples. You see biotechnology sitting at 13% of the index right now, and software making up about 11%. So when you collectively think about that, most of those industries are bigger than a lot of the sectors in the benchmark itself. That, to me, is some meaningful concentration.

Peter Crivelli:
Thanks, Matt. Has this concentration occurred gradually or is this just a more recent phenomenon?

Matt Orton:
I think that's where we see some differences start to emerge when you split growth and value. Going back to the small-cap value, the Russell 2000 Value Index, financials and banks have been pretty consistent with respect to their weight over time. If I go back all the way to 2001, their weights have been pretty stable and the weights today are nearly the same as they were over two decades ago. So there's been stability in that concentration. But when we look at growth, really the weight of biotechnology and healthcare, that's what's increased most dramatically, just over the past handful of years. 20 years ago, biotechnology was less than 10% of the Russell 2000 Growth, and it stayed this way largely through, I think it's about 2013. Biotechnology had a remarkable year of performance in '13, and that's when we started to see the weight increase and it's been relentless ever since then.

At the end of the first quarter of 2021, biotechnology comprised over half of the total healthcare weight in the index and together with pharmaceuticals, it comprised nearly 66% of the healthcare sector, so very, very concentrated. Biopharma collectively peaked at nearly 22% of the Russell 2000 Growth Index earlier this year. And the only reason that it decreased is because some of those names exploded higher and were reconstituted out of the index into midcaps. So you've seen really extreme growth in concentration in the small-cap growth part of the market.

Technology has also grown meaningful in weight within the Russell 2000 Growth over the past few years. It's largely been the result of really strong performance in software and semiconductors. You've had good performance again, really since growth took off within the market post-2017, and you've seen meaningful growth in those sectors as well. It's been more stable in value and a lot more strong in growth. What I would say is, is the strong price appreciation that you've seen within healthcare and information technology, it causes an increase in valuations and then you get a tsunami of new deal issuance in these areas and that helps to keep the weights on the rise, even when you have changes around reconstitution.

Peter Crivelli:
Thank you, Matt. Biotech, or biopharma as you put it, is worth a deeper dive. It's a uniquely American industry and has really gained a lot of attention in the last 18 months or so. Why do you think biotech has grown so much, and is this a sustainable trend?

Matt Orton:
Yeah, biotechnology Peter, is different today than it was 20 or 10 or even five years ago. Overall, I think the space has matured and is more than a collection of just highly speculative microcap companies that oftentimes I think we tend to think of it as. Between 2019 and 2020, biotech saw double digit annual growth and fundraising from venture capitals or VCs, as I'll call it, in deals such as partnerships, co-developments in joint ventures. You also saw triple digit growth in IPOs just over the past year. That's extreme growth very, very recently. And venture capital activity in particular has really increased over the years and it just continues to grow at a torrid pace. In 2020 alone, venture capital activity in biotech grew by 45% and it took the 2020 global total to $36.6 billion dollars.

U.S. biotechnology, and as you pointed out, it is a pretty American industry. U.S. biotechs by far and away led on investments, but we're starting to see an increase in activity in Europe and also in China. In China, I think this is interesting, the number of funding rounds for VCs grew four times faster than in Europe and the United States. So you're definitely starting to see some increased interest overseas, but it's still a very small portion of overseas small-cap indices.

So I think another good question to ask then is, what's driving all of the interest that VCs have in biotech? As I mentioned a minute ago, I believe that a lot of VC investors believe that biotech has matured as a business and that it carries lower risk than it did in the early days. I think others might say that it has suffered from chronic under-investment in the past, and it's starting to play catch up. I certainly wouldn't disagree with that. I think another important point to make is that investments in the industry are partly driven around the need to diversify VC portfolios just from around information technology.

You're also starting to see more institutional consultants allocating to alternatives. Some of that then goes into the VC space, which then goes into biotechnology as part of that allocation. I think VCs have definitely been a key driver of some of that increase, but we've also seen a big increase in IPO activity. And that's increased the number of companies that have been entering the benchmark. IPO fundraising, I believe brought in just over $34 billion dollars in 2020 alone, which represents an increase of 186% over the previous years. So just a ton of growth all around.

Peter Crivelli:
Thanks, Matt. My next question is on the quality factor and profitability. Many of our listeners are aware of the large number of loss making companies in the Russell small-cap indices. Has the growth in biotech and in software driven the increase in loss making companies?

Matt Orton:
Yeah, it absolutely has. And I would say that the increased concentration that you've seen in biotechnology and software has definitely had a big impact on profitability and I would say quality. Non-earners right now compose almost 35% of the Russell 2000 Index and they make up over 41% of the Russell 2000 Growth. To your point, Peter, not surprisingly, how the decline in profitability starts to increase, is biotech starts to increase in weight around 2013. You really saw both of them take off over the past couple of years. And believe it or not, the Russell 2000 Growth peaked at nearly 45% non-earners earlier this year, when you saw that peak in biopharma weight within the index. That's all almost half of the weight of the benchmark in loss making companies. It's definitely a direct result of the spike that you've seen in the weight in biotech and also software over the past few years.

To address another point, because you mentioned quality, I think it's worth noting that being a loss making company isn't necessarily a bad thing. A lot of software companies will plow back revenues, reinvesting into their businesses to drive more and accelerating top line growth. And in those cases, it's okay to be loss making. But in some other cases, in many biotech companies in particular, the loss makers there have a very different profile. There really aren't any tangible revenues to speak of. They're dependent on fundraising. I almost call them publicly funded science projects. And granted they have very meaningful implications for health and it's a fantastic place to find and develop future drugs that are going to be very, very important for global health, but the profile of these companies is vastly different. Those types of loss makers are very different from say, the loss makers that you tend to get in software or semiconductors or other, I'd say, growth pockets of the market.

Peter Crivelli:
Thanks, Matt. I think the next question is whether the increase in loss making companies is driven by increased concentration. How has this impacted the small-cap space?

Matt Orton:
Yeah, I think that's a good question. You've seen the increased concentration, the increase in loss making companies have an impact on overall performance. Given the record rallies we saw in the Russell 2000 in the fourth quarter of last year, the first quarter of this year, it might not appear that it's had too negative of an impact. But I would say that it's much more nuanced than what you might see on the surface. I think that's also why small caps have largely been treading water up until very, very recently, since February of this year. We all know that information technology, that has performed very well over the past few years and in particular, software companies and the highest growth, longest-duration assets have really been rewarded by investors. That has definitely helped small-cap performance and especially small-cap growth performance.

Last year, biotech performed pretty darn well too. The focus on the need for innovation around COVID treatments and vaccines all provided some additional tailwinds, but the performance is incredibly volatile. You saw, like I'd mentioned before, the Russell 2000 posted its best performance on record in the fourth quarter of last year and it posted its second best quarter of performance in the first quarter of this year. But biotech has meaningfully underperformed and software has also started to be hit a little bit hard. That's led to performance volatility and you've seen that continue well into this year.

Profitable companies across the Russell 2000, the Russell 2000 Value, and the Russell 2000 Growth have logged pretty similar returns. They've been up between 14% and 18% year-to-date. But loss makers, they have meaningfully underperformed, and particularly and the Russell 2000 Growth. They're down 10% year-to-date and they're dragging down the performance of the overall index. There's a meaningful performance gap so far this year between the Russell 2000 Value and the Russell 2000 Growth and you don't see anywhere near as wide of a gap of market cap. It's largely because of the volatility you've seen in particular, biotechnology and the concentration that you have in the small-cap space. I would lay the blame on biotech so far this year and that volatility is definitely something that you want to pay attention to going forward.

Peter Crivelli:
Thanks, Matt. You've addressed the benchmarks, but how have active managers fared? What are they doing to help them perform in this environment? Is this a potential risk going forward?

Matt Orton:
Yeah, active managers have held up pretty well down the market cap spectrum. And interestingly, active managers have been fairing the best in the small-cap growth space. Ironically, in the areas where we have the highest concentration down market cap, you've been seeing the best performance from active managers. It's pretty interesting because active managers have been taking very large sector and industry bets. It's evident in growth and it's evident in value. I would point out value managers have been leaning into growth. On average, value managers are overweight consumer discretionary by almost five percent. They're overweight information technology and particular software and their underweight biotechnology and healthcare within the value index. So by and large, they're leaning into growth.

On the flip side, small-cap growth active managers are taking larger bets and seem to be leaning into value a little bit. They are decreasing their overweight to information technology, their underweight healthcare meaningfully by over four percent, their overweight industrials and their overweight financials. What I would note is that throughout 2020, software was a very meaningful overweight, but it's now underweight by over 100 basis points. That weight has been shifted into more value parts of the market like financials and industrials.

But what really stands out is the underweight to biotechnology. The active underweight to biotech by small-cap growth managers is over 700 basis points and that has come down, believe it or not, over the past couple of quarters. So it's a concentrated part of the market, it's a volatile part of the market, and it's interesting that active managers have been avoiding that space. And that's paid off pretty well for them because software by and large has done well up until probably later last year, earlier this year as growth didn't perform as well. Biotechnology under-performed for a few years in the past and its outperformance last year was largely offset by the overweights that active managers had to software and other parts of IT.

It's interesting when you look, but the underperformance of biotechnology just taking this year alone, I believe biotech is down about 13% in the Russell 2000 Growth. You couple that with that very, very large underweight, 91% of small-cap growth active fund managers outperformed their benchmark in the third quarter of 2021. On a one year basis, 67% are outperforming. That's the highest across all nine style boxes and at weight away from the concentrated parts of the market where the most concentrated part of the market has definitely paid off and small-cap growth managers are by far and away, outperforming everyone else across the style boxes. And it largely comes down to these very, very large sector bets that they have been taking. So whenever we speak with clients, we always like to remind them that really, it's important to understand the concentration that you have in the benchmark. And it's also important to understand what active managers are doing and how they're getting their performance.

Peter Crivelli:
Well, thank you Matt, for sharing that. And we'd like to keep the conversation going, but that's about all the time we have today. Do you have any final words you want to add, Matt?

Matt Orton:
Thanks, Peter. I've definitely enjoyed the conversation and again, I'll thank all of our listeners for tuning in and until next time, take care. Thanks for listening to markets in focus from Carillon Tower Advisers. Please find additional episodes and market insights at You can also subscribe to our podcast on Apple podcasts, Spotify, or your favorite podcast app until next time, I'm Matt Orton.


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