The Barron’s 400 Index is up 1.3% so far this year (price-only return through Wednesday’s close) but the last year has not been a kind one to the index. It has done poorly in the last 12 months mostly as a result of its exposure to the small cap segment of the market and, to a lesser extent, to its exposure to growth. This is not the first time this has happened nor will it be the last. So, for those of you tracking the index or investing in the fund that tracks it, we figured some historical perspective is in order.

Market returns, as most investors know, have two sources: asset allocation and security selection. The Barron’s 400, a stock picker’s index, is based on the latter. Its allocation to style and size, important determinants of short-term investment returns, is purely incidental as a result of the bottom-up, fundamentals-based selection of its constituents. Such selection is focused on a simple premise: own the best companies, with the best growth prospects, at a reasonable price, and focus on long-term capital appreciation. In fancy market jargon, B400 is strategic, not tactical. And the strategy has worked: the index has bested the Dow Jones US Total Stock Market Index by 110 basis points per year over the last decade, an advantage that has been as wide as 300 basis points annually, also over a decade, based on what the market has done in the short-term. 

Deliberately ignoring tactical trends, of course, has short-term consequences. B400’s size and style exposure will, in any given 12-month period, work for or against its performance as market trends will affect fundamentally-sound stocks based on tactical market shifts, regardless of the companies’ intrinsic value. In the long run, though, these trends revert to the mean, which in our case means the market eventually values companies sensibly based on their underlying worth, rewarding patient and opportunistic capital in the process.

The last year has been a poor one for the stock market in general. The Russell 3000, which encompasses well over 98% of its market cap, was down 3.7% as of this writing (Tuesday’s close). It has been particularly poor for small caps, with the Russell 2000 down 9.3%. Large caps, as measured by the Russell 1000, had only lost 3.2% in the last 12 months. It has also been a poor year for both growth and value, particularly the latter, although that has begun to change (more on this later). The Russell 3000 Growth is down 2.9% in the last year while the Russell 3000 Value has lost 4.6%. The following analysis is based on the interplay between the market’s size and style benchmarks (based on Russell indexes) in the short-term and the effect these have on the Barron’s 400. Figure 1A illustrates the performance in the last year of the four Russell Size and Style benchmarks.

Figure 1A – Performance of Russell Benchmarks – 1 Yr. as of 5/24/16

Benchmark Performance	Value	Growth	Average
Large	-4.36%	-2.06%	-3.21%
Small	-6.74%	-11.93%	-9.34%

Benchmark performance based on Russell Style and Size Indexes. Source: FactSet  

Of the four benchmarks, Small Cap Growth (based on the Russell 2000 Growth Index) has done the worst by a wide margin. It was followed by Small Cap Value (Russell 2000 Value Index), then Large Cap Value (Russell 1000 Value Index) and, finally, Large Cap Growth (Russell 1000 Growth Index), which was down only 2.1%. This last one is, by the way, where you may find the “FANG” stocks, which have captured the imagination of so many investors. Looking at B400’s exposure to these four benchmarks over the last year explains its performance in the last 12 months, in which the index has lost 9.7% (as of Tuesday), as illustrated by Figure 1B.

Figure 1B – B400 Size and Style Exposures – 1 Yr. as of 5/24/16

B400 Exposures	Value	Growth	Total
Large	28%	14%	42%
Small	26%	32%	58%

Benchmark performance based on Russell Style and Size Indexes. Source: FactSet  

Tactically, B400 has been poorly positioned in the last 12 months, with 32% of its exposure to the segment that did the worst (Small Cap Growth) and its smallest allocation to the one that did the best (Large Cap Growth). As a result of B400’s ‘factor loading,’ a fancy way to say its exposure to size and style, 73% of the index’s performance came from its ‘tactical’ positioning and only 27% from its stock selection, as illustrated in Figure 2.

Figure 2 – Size and Style Contributions to B400 Performance – 1 Yr. as of 5/24/16

Performance Contribution	Value	Growth	Total
Large	-1.22%	-0.29%	-1.51%
Small	-1.75%	-3.82%	-5.57%
Total	-2.97%	-4.11%	-7.08%

Benchmark performance based on Russell Style and Size Indexes. Source: FactSet

In summary, what was most detrimental to B400’s performance in the last 12 months was its exposure to small caps (-5.57%) followed by its exposure to growth (-4.11%). As we mentioned before, such tactical ‘misallocations’ have happened in the past and will happen again. The questions B400 investors should ask are, in our opinion, these: 1) How have size and sector exposures helped or hurt B400’s capital appreciation goal in the long run? 2) Tactically speaking, where in the cycle are we now and how is B400 positioned? And, 3) What has the index done following bouts of similar underperformance? Our answers to all three questions appear next.

We’ll start by looking at B400’s size and style exposures and contributions to performance in the last 10 years, a long enough period for long-term capital appreciation. Figures 3A and 3B illustrate B400’s factor exposures as well as the performance of the individual benchmarks during this period.

Figure 3A – Performance of Russell Benchmarks – 10 Yrs. as of 5/24/16

Benchmark Performance	Value	Growth	Average
Large	40.25%	98.24%	69.25%
Small	34.95%	86.92%	60.94%

Benchmark performance based on Russell Style and Size Indexes. Source: FactSet

Figure 3B – B400 Size and Style Exposures – 10 Yrs. as of 5/24/16

B400 Exposures	Value	Growth	Total
Large	16%	34%	50%
Small	0%	50%	50%

Benchmark performance based on Russell Style and Size Indexes. Source: FactSet  

Not surprisingly, during the last decade B400’s size exposure has been exactly evenly split between large and small caps, at exactly 50% each. In other words, from a returns-based perspective, B400 has fallen squarely in the middle (or mid cap segment), what we like to call “the market’s sweet spot.” Additionally, 84% of its allocation was to growth and only 16% to value. B400’s price-only return in the last 10 years was 91.3%. Figure 4 illustrates the effects that the index’s factor exposures had on its return in the last decade.

Figure 4 – Size and Style Contributions to B400 Performance – 10 Yrs. as of 5/24/16

Performance Contribution	Value	Growth	Total
Large	6.44%	33.40%	39.84%
Small	0.00%	43.46%	43.46%
Total	6.44%	76.86%	83.30%

Benchmark performance based on Russell Style and Size Indexes. Source: FactSet  

This analysis makes clear that, in terms of asset allocation, B400’s exposure to growth across large and small stocks was the primary factor in driving its excellent performance. By comparison, the value factor contributed less than one tenth of what growth contributed. So, strategically (long-term), B400’s exposures seem to have been very favorable in the last decade. Keep in mind, though, that B400 rebalances twice a year, reshuffling its list of constituents based on the quality of their fundamentals. These changes help explain the shifts across size and style, which, of course, make B400 so different to traditional static benchmarks, which always seek a single exposure. Figure 5 illustrates the shifts in factor exposure for B400 within the last ten years, looking at sub-sets of this time frame, all ending this week.

Figure 5 – B400 Size and Style Allocation Shifts Within Last Decade

Style Exposure	YTD	1 Year	2 Years	3 Years	5 Years	Since 2009	10 Years
Value	50	54	52	49	33	21	16
Growth	50	46	48	51	67	79	84
Size Exposure
Large	42	42	45	46	45	51	50
Small	58	58	55	54	55	49	50

Benchmark performance based on Russell Style and Size Indexes. Source: FactSet  

Figure 5 reveals something remarkable about B400’s tactical shifts: while the index is constantly shifting across size and style factors, the changes across styles are much bigger than those across size. This, of course, makes perfect sense, as B400’s methodology is always looking for growth at a reasonable price. For example, when the stock market bottomed in March 2009, B400 was finding plenty of value across broad market segments; put another way, growth was very cheap so it loaded up on it (Figure 6). More recently, growth has become pricier, so the index has tilted towards value. Nevertheless, when seen over a ten-year period it is clear that B400 is a mid cap growth index regardless of its short-term or tactical shifts.

Figure 6 – B400 Size and Style Exposures, Benchmark Returns and Contribution to Performance Since March 2009 Market Bottom as of 5/24/16

B400 Exposures	Value	Growth	Total
Large	18%	33%	51%
Small	3%	46%	49%
Benchmark Performance	Value	Growth	Total
Large	197.52%	228.27%	425.79%
Small	204.20%	258.06%	462.26%
Performance Contribution	Value	Growth	Total
Large	35.55%	75.33%	110.88%
Small	6.13%	118.71%	124.83%
Total	41.68%	194.04%	235.72%

Benchmark performance based on Russell Style and Size Indexes. Source: FactSet

So, where is the stock market today, tactically speaking, and what does this mean for B400? Figure 7 offers a good idea of where the market seems to be going.

Figure 7 – 12-Month Rolling Value-Growth Spreads by Size, Last Decade

The chart in Figure 7 depicts the spread in rolling 12-month returns between value and growth, controlling for size, during the last ten years. Any time that the blue line appears above zero, large cap value has outperformed large cap growth; and any time the red line appears above zero, small cap value has outperformed small gap growth. Both lines are highly correlated. According to the chart, the stock market seems to be entering a value phase, or a period where value has seemingly begun to outperform growth. For small caps this trend began in February (in fact, it started about a year ago since the lines are based on rolling 12-month returns). And now large cap stocks seem headed in the same direction, with value expecting to outperform soon. If history is any guide, we have seen tentative lunges in the direction of value (see chart around 2013), only to see strong reversions to growth. The bottom line is no one knows where this trend will go or how long it will last.

But, assuming this trend holds, based on historical market patterns, how long can we expect value to outperform growth? Not too long. The last value market lasted seven months for small caps (Oct. 2002 to May 2003) and eleven months for large caps (Sep. 2002 to Oct. 2003). Furthermore, when looking at all 12-month rolling periods in the last decade, it is clear that value periods have been much shorter than growth periods. Since the beginning of the decade in our analysis (May 2006) there have been 109 12-month rolling periods (through this week). Among large caps, value has outperformed growth in 25 periods, or 23% of the time. Growth has outperformed value in the remaining 84 periods, or 77% of the time. Among small caps, the contrast between both styles is even starker. Small cap value stocks have outperformed in 22 periods, or 20% of the time while small cap growth stocks have outperformed in 87 periods, or 80% of the time. Figure 8, which shows the inverse of the chart in Figure 7, illustrates this clearly.

Figure 8 – 12-Month Rolling Growth-Value Spreads by Size, Last Decade

So, from a historical perspective, at least in the last decade, B400’s predominant growth tilt should continue to serve it well assuming growth periods continue to outnumber value periods 4-to-1, or in some similar proportion. However, in order to answer the third of the questions we raised before, we took a look at B400’s rolling 12-month performance in the last decade to see where the index has gone following periods of 12-month underperformance as has been the case in the last 12 months. Figure 9 tells part of the story.

Figure 9 – 12-Month Rolling B400-Russell 300 Spreads, Last Decade

During the last decade, which includes 109 rolling 12-month periods, B400 has outperformed the Russell 3000, a proxy for the broad U.S. stock market, in 74 of them, or 69% of the time. During the whole decade, B400 has underperformed the Russell 3000 on nine different occasions, excluding the most recent one, with the shortest times lasting only one month and the longest lasting nine months. On average, all spells of underperformance lasted three months. The current one is now seven months old, making it the second longest on record in the last decade. And while we won’t argue that the current phase could not last much longer, we also don’t like to argue against historical reversions to the mean. Put more succinctly, you may bet against B400 tactically but if history is any guide, don’t do so strategically.