Two Style Boxes Can Be Better than One: The Case for Small-Mid Cap Equities

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1 Investment Focus Two Style Boxes Can Be Better than One: The Case for Small-Mid Cap Equities Within US equities, investors have long used small cap stocks to diversify their large cap holdings, but we believe they should also consider an allocation to small-mid cap equities. In our view, the small-mid cap asset class combines many of the attractive growth attributes and diversification benefits of small caps, but with greater flexibility, breadth of opportunities, and some stability characteristics typically associated with large firms. The risk-return profile of small-mid caps has been more attractive and the asset class has greater liquidity compared to small caps. As a result, we believe US smallmid cap equities can bring several potential benefits to investors and play a vital role in their portfolios.

2 2 Introduction: The Small-Mid Cap Solution Investors have largely embraced the concept of diversification in regard to asset allocation: large cap versus small cap, growth versus value, developed versus emerging. In our view, one of the most challenging asset classes to implement is small cap equities, due mostly to its lack of liquidity compared to other asset classes. For example, over the last 1 years, the value of shares traded daily in the 2 is $6 billion, while the value of shares traded in the S&P 5 over the same time frame is $35 billion. 1 While market liquidity does not solely determine a manager s capacity, we believe this lack of liquidity in the small cap market causes many managers to close their funds at relatively low levels of assets under management. In fact, over a third of 5-star rated US small cap funds are closed. 2 In addition, small cap managers with higher assets under management may be challenged from a performance perspective. More than half of small cap fund managers with more than $3 billion in assets have ranked in the bottom 5% of their peer group over the last three years. 3 For investors seeking small cap exposure, we believe a possible solution lies in US small-mid cap equities. In our view, many investors do not appreciate the similarities of the small and small-mid cap asset classes. We base this assumption on the fact that assets under management in the small-mid cap universe $295 billion are much less than the $667 billion of assets under management in the small cap asset class, despite the much larger opportunity set available in small-mid cap equities. 4 To begin our discussion, we clarify what small, mid, and smallmid cap mean: Small cap stocks are generally considered securities that are less than $2 billion in market cap. The standard performance proxy is the 2, which is composed of the 2 smallest companies in the 3 (an index which comprises 98% of the investable US market). Its total market cap generally represents only 1% of the larger index. 5 Mid cap stocks are generally viewed as stocks with market caps ranging from $1 $1 billion, and are typically represented by the Midcap. This index consists of the smallest 8 stocks of the 1 (the 1 largest stocks in the 3 ), and comprises about 3% of the market cap of the 3. Small-mid cap stocks are typically thought of as stocks that are less than $1 billion in market cap. Small-mid cap equities are generally represented by the 25, which comprises the smallest 25 stocks of the 3, covering the entire 2 and roughly 6% of the Midcap. Importantly, the indices are rebalanced annually to preserve the integrity of the opportunity set. In Exhibit 1, we display the characteristics of each asset class. US Small-Mid Equities Offer Diversity and Performance Benefits One of the reasons that investors allocate to small caps is to diversify their large cap exposure. However, small-mid cap equities can offer these diversification benefits as well and have a greater range of opportunities. Over the last 2 years, both US small caps and US small-mid caps have had a similar, lower correlation to the broad market, 6 with the 2 having a correlation of.81 as compared to.86 for the 25. Perhaps not surprisingly, 2 and 25 performance is highly correlated, with a.99 correlation over the last 2 years. 7 The rolling performance patterns of small caps and small-mid caps are also remarkably similar (Exhibit 2). As illustrated in Exhibit 3, small-mid equities have generally outperformed small caps. On a rolling 5-year basis over the last 2 years, the 25 has outperformed the 2 98% of the time. One might assume that the outperformance of US small-mid caps relative to US small-caps is due to small-mid caps being riskier, but this would be incorrect. Over rolling 5-year periods, small-mid caps have actually exhibited less risk than small caps (Exhibit 4). In aggregate, over the last 2 years, small-mid caps have generated an annualized return of 1.3%, outperforming the small cap return of 8.8%, but with a lower standard deviation (18.4 versus 19.8). 8 We believe part of the reason for this outperformance at a lower level of volatility is that Exhibit 1 US Asset Class Characteristics: Small, Mid, and Small-Mid Cap Equities Exhibit 2 US Small-Mid and US Small Caps Have Similar Historical Performance Patterns ($B) 15 1 Median Market Cap Weighted Average Market Cap Rolling 5-yr Returns (%) Small Cap Mid Cap Small-Mid Cap As of 31 July 215 Small Cap = 2 index; Mid Cap = Russel Mid Cap ; Small-Mid Cap = 25 Source: As of 3 June 215. All data calculated monthly. The performance quoted represents past performance. Past performance does not guarantee future results. The indices mentioned above are unmanaged and have no fees. It is not possible to invest directly in an index. Source: Lazard,

3 3 Exhibit 3 US Small-Mid Caps Have Historically Outperformed US Small Caps Rolling 5-yr Returns (%) Exhibit 4 US Small-Mid Caps Have Historically Exhibited Less Risk than US Small Caps Rolling 5-Year Standard Deviation As of 3 June 215. All data calculated monthly. invest directly in an index. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. Source: Lazard, As of 3 June 215. All data calculated monthly. Past performance does not guarantee future results. Source: Lazard, 215 the small-mid universe includes successful companies that graduate to a higher cap range, allowing small-mid cap managers to maintain ownership of their successful positions rather than being forced to sell them and then attempting to identify new sources of outperformance. Building upon the idea of risk and return, we examined the capture ratios 9 of the small, small-mid, and mid cap asset classes. When the broad market rises or falls, the capture ratios of small caps tend to be high, which intuitively makes sense. Small cap stocks are typically more reliant on the economic cycle because they generally have fewer tools to manage their balance sheets as compared to large caps. The capture ratios of mid cap companies are also high but less so than small caps. Mid cap companies are generally more mature businesses and tend to have less volatility than small caps as they are further along in their evolution. The mid cap opportunity set may also contain fallen angels, or larger-cap stocks which have decreased in size. The market capture ratios of small-mid cap companies are between that of small and mid caps (Exhibit 5), which we believe demonstrates that the small-mid cap asset class can deliver the upside that investors seek while offering the downside protection provided by more established businesses. Exploiting Market Inefficiencies The small cap space is generally considered less efficient than that of large cap. Part of this inefficiency stems from the small amount of research coverage that small cap, as well as mid cap, stocks receive. Small cap stocks have an average of only seven analysts covering each stock. Research coverage increases to nine analysts on average for the smallmid cap opportunity set, still well below the average of 17 analysts in the mid cap space and the 24 analysts in the large cap universe (Exhibit 6). Interestingly, research coverage is even higher for many wellknown mega cap stocks: Apple, for example, is covered by 55 analysts, Facebook by 54 analysts, Google has 52 analysts, and Intel is covered by 5 analysts. We believe that this lower level of research is particularly helpful for active managers, who can exploit the information gap between the company and the market. In our view, this trend can be seen by examining the degree to which active managers have outperformed Exhibit 5 US Small-Mid Caps Have Attractive Capture Ratios Compared to US Small Caps Market Capture of the S&P 5 Last 15 Years (%) Small Cap Up Capture 25 Midcap Down Capture Last 2 Years (%) Small Cap 25 Midcap As of 3 June 215 Past performance does not guarantee future results. Source: Lazard, Exhibit 6 US Small and US Small-Mid Cap Stocks Receive Low Levels of Research Coverage Sell-Side Analysts Asset Class Average Median S&P 5 (Large Cap) Midcap (Small-Mid Cap) (Small Cap) 7 6 As of 24 August 215 Source: Bloomberg

4 4 their various indices. Over the last 1 years, the outperformance of small cap and small-mid cap managers has exceeded that of large cap managers relative to their respective benchmarks (Exhibit 7). We believe part of the outperformance of the 25 is a result of its less-constrained opportunity set compared with the 2. Small-mid cap managers can hold winners for longer as smaller, successful companies grow in size. Exhibit 7 US Small and US Small-Mid Cap Managers Have Historically Added More Alpha than Larger Cap Managers Annualized Excess Return, Last 1 Years (bps) US Small 155 US Small-Mid US Mid US Large Data are through 3 June 215, as reported on 24 August 215. Past performance does not guarantee future results. Not intended to represent any product or strategy managed or offered by Lazard. Small cap is represented by the US Small Equity universe, small-mid cap by the US Small-Mid Equity universe, and large cap by the US Large equity universe. The number of peer observations comprising the US Small Equity universe is as follows: 1 years 81. The number of peer observations comprising the US Small-Mid Equity universe is as follows: 1 years 43. The number of peer observations comprising the US Mid Equity universe is as follows: 1 years 57. The number of peer observations comprising the US Large Equity universe is as follows: 1 years 264. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. Please refer to the attached disclosures for important information regarding the composite. Source: evestment Alliance, Lazard Conclusion In conclusion, we believe that investors interested in diversifying their large cap equity allocation should consider investing in small-mid cap equities. The small-mid cap asset class combines many of the attractive growth attributes and diversification benefits of small caps with some of the stability characteristics associated with larger firms. The riskreturn profile of the small-mid cap asset class, as well as its enhanced liquidity compared to small caps, can bring significant benefits to investors and play a vital role in their portfolios. Lazard s Small-Mid Strategy The Lazard US Small-Mid Cap Equity strategy invests in financially productive small and mid cap companies with attractive valuations. The strategy seeks to outperform the 25 in all market environments by taking advantage of the diverse opportunity set offered by the small and mid cap universe. The strategy typically invests in 7 9 securities of companies with market capitalizations between $35 million and $1 billion at purchase, or that are included in the 25. The four-person portfolio management team is led by portfolio manager/analyst Daniel Breslin, who has specialized in small and mid cap equities for more than 17 years. They are supported by members of the US Equity platform, which totals 23 investment professionals averaging more than 18 years of industry experience and a tenure at Lazard of 12 years. Think Bigger Small-mid cap allocations may be especially attractive to defined contribution (DC) plan sponsors, who have been streamlining the number of funds in the core investment lineup to ease participant decision-making, maximize plan usage, and achieve more successful outcomes. In the context of discussions regarding the role of small cap stocks in DC plans, small-mid cap equities may be a sensible replacement for small cap, as the asset class has the potential to deliver greater returns at lower risk.

5 5 About the Team The Lazard US Small-Mid Cap Equity strategy team seeks to outperform the 25 by investing in financially productive small and mid cap companies with attractive valuations. The four-person portfolio management team is led by portfolio manager/analyst Daniel Breslin, who has specialized in small and mid cap equities for more than 17 years. Other members of the portfolio management team include Michael DeBernardis, Eugene Krishnan, and Martin Flood. They draw upon the firm s extensive network of investment professionals, primarily a dedicated team of more than 2 experienced US equity analysts. This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 As of 31 August 215. Source: Bloomberg 2 As of 31 July 215. Source: Morningstar Direct. Closed refers to funds which have either a soft or a hard close. There are 27 5-star US small cap (core, growth, and value) funds, and and 5-star funds. 3 As of 31 July 215. Source: Morningstar Direct 4 As of 3 June 215. Source: evestment. Small cap measures the US Small Equity, value, and growth universe. Small-mid cap measures the Small-Mid Equity, growth, and value universes. 5 Source: 6 We define the broad market as the S&P 5. 7 As of 31 July 215. Source: Lazard,. invest directly in an index. The performance quoted represents past performance. Past performance does not guarantee future results. 8 As of 31 July 215. Source: Lazard, 9 Capture ratio measures an asset class s performance in relation to a benchmark. It is a percentage of the benchmark s performance. If the asset class s performance matches the benchmark, then its capture ratio is 1%. If it outperforms the benchmark on the upside, the ratio exceeds 1%; if it outperforms on the downside, the ratio is less than 1%. On the other hand, if the asset class underperforms the benchmark on the upside, the ratio will be less than 1%; if it underperforms on the downside, the ratio will be more than 1%. Important Information Published on 7 January 216. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of 5 November 215 and are subject to change. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable, their prices more volatile, and their liquidity less than that of large-capitalization or more established companies securities. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) and sources believed to be reliable as of the publication date. 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