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RUSSELL 2000® INDEX QUARTERLY ANALYSIS

SMALL CAP PERSPECTIVES

December 2016

01FTSE Russell | Small Cap Perspectives: Russell 2000® Index Quarterly Analysis

Market Recap Commentary – Fourth Quarter 2016

1 Lincoln and the Founding of the National Banking System (2017). Office of the Comptroller of the Currency, retrieved on January 23, 2017 at: https://www.occ.gov/about/what-we-do/history/lincoln-founding-national-banking-system.html2 Curry, P. (2017). How a Supreme Court ruling killed off usury laws for credit card rates. CreditCards.com, retrieved on January 20, 2017 at: http://www.creditcards.com/credit-card-news/marquette-interest-rate-usury-laws-credit-cards-1282.php3 Presidential election period defined herein as: December month-end total return value/October month-end total return value.

The Trump Bump?

In 1864 Congress, under the direction of Treasury Secretary Salmon Chase and President Abraham Lincoln, passed the National Banking Act. The bill established a federally supported system of banks and a common currency — all needed at the time to provide an additional financing apparatus to fund the Civil War. 1 Fast forward 114 years — to 1978 — and a Supreme Court case entitled Marquette vs. First of Omaha interpreted the National Banking Act as allowing for banks to charge variable interest rates as allowed by their “home” state. This meant fewer restrictions on credit card and other bank rates and ushered in a new era of deregulation and growth within financial services. Its also the reason most of the credit card solicitations in your mail originate from South Dakota or Delaware — states that give banks the most latitude.2

The fourth quarter reaction of the Russell 2000® Index’s Financial Services Sector to Donald Trump’s election as President of the United States suggests that the market is anticipating another such period of enhanced profitability, particularly for banks. As shown in Figure 1, the “Trump Bump” was the highest return (14.3%) for the Russell 2000 Index of any presidential election period since its inception in 1979.3 George W. Bush’s (Bush 43) election in 2004 sparked the second highest return (+11.9%), followed by Clinton in 1992 (+11.4%). Bush 43’s election in 2000 and Obama’s election in 2008 had the lowest returns, but occurred during challenging economic times that likely overwhelmed any positive presidential sentiment.

Of this apparent post-election bounce for the market as shown in Figure 2, the Russell 2000 Index’s Financial Services and Energy sectors had the highest performance. Financial Services finished the fourth quarter with a 17% return, the highest of any sector in the Russell 2000 Index. That quarterly return was the largest for the sector since the third quarter of 2009 as financial companies left for dead began to revive. If we isolate just the November and December time period around the election, we can see that returns across sectors jump and the Energy sector rises to the top with a +25.9% return.

Figure 1: Post-election returns of the Russell 2000 Index and Russell 1000 Index

-10

-5

0

5

10

15

20%

Trump 16 Bush 04 Clinton 92 Clinton 96 Obama 12 Reagan 80 Bush 88 Reagan 84 Bush 00 Obama 08

Russell 2000 Index Russell 1000 Index

Figure 2: Post election tide raises all boats – Sector returns and post-election period returns (Nov – Dec)

Source: FTSE Russell as of December 30, 2016.(continued)

UtilitiesConsumerStaples

Energy Materials &Processing

ConsumerDiscretionary

ProducerDurables

HealthCare

FinancialServices

Technology

-10

-5

0

5

10

15

20

25

30

Post-election period 4Q 16

%


Whether or not the market’s expectations are realized as the Trump administration takes power remains to be seen, but it seems clear that political risk — for better or worse — will help to drive the markets as we enter 2017. But, as reported at the end of last year [See the Small Cap Perspectives, December 31, 2015 report], long-term returns are more likely to be influenced by the Fed, oil prices, and international events.4 The Trump presidency could, however, carry an outsized influence on the economy — small caps in particular — depending on the policies pursued.

Trump takes office as the Fed begins what it anticipates is a slow and winding march towards a historically normal range for the federal funds rate (FFR). In December the Fed’s Open Market Committee voted to raise the FFR a quarter point to 0.5–0.75%. This was just the second rate hike by the Fed since December, 2015, as it laboriously tightens monetary policy. Across recent cycles of rate increases by the Fed, beginning with moves made in 1994, the 12-month gap (December 2015 to December 2016) between the first and second rate hikes was the longest such span. In the Fed’s estimation the US labor market continues to trend positively, and inflation remains below 2%; thus achieving both of its stated primary goals and setting the stage for further increases in 2017.5

It’s worth pausing here to remember that the Russell 2000 Index has historically proven a uniquely sensitive gauge of the health of the US economy. With that in mind, it is perhaps fair to question how much of the “Trump Bump” is attributable to the currently robust US economy — something difficult to parse. Recent research by FTSE Russell has discovered a pattern of small cap returns around the peaks of past economic cycles that behaves differently than the market overall [See FTSE Russell Blog, Sunny with a chance of recession: Weathering the business cycle, January 3, 2017]. If this behavior holds in the future, it could provide a guide as to where we were in the business cycle when Trump was elected, and what kind of boost Trump and his administration’s policies provided, if any.

As shown in Figure 3, small caps, as measured by the Russell 2000 Index, have finished better under every presidential term except for Bush 43’s second term, which began in 2004. The first Clinton term starting in 1992 saw small caps post their best 48-month performance of any four-year term evaluated. The second Reagan term beginning in 1984 saw the largest drawdown of the Russell 2000 Index during any presidency, falling close to 35.6% following the market selloff in October 1987. The first term for Clinton was also the only full 48-month period where the performance of small caps did not fall below their starting value.

Figure 3: 48-month cumulative returns for the Russell 2000® Index from each presidential election (Nov – Oct).

1980 (Reagan) 1984 (Reagan) 1988 (Bush 41) 1992 (Clinton)

1996 (Clinton) 2000 (Bush 43)

Number of months from election

Gro

wth

of a

uni

t (ba

se 1

00)

2004 (Bush 43) 2008 (Obama)

2012 (Obama)

Base 22204 6 8 10 12 14 16 18 3024 26 28 32 4034 36 38 42 44 46 4820

50

100

150

200

250

Sources: FTSE Russell and MPI Stylus as of December 31, 2016. Certain results shown reflect hypothetical historical performance. Past performance is no guarantee of future results. Please see important legal disclosures at the end of this report.

Market Recap Commentary

4 Binder, A.S. & Watston, M.S. (2013). Presidents and the Economy: A Forensic Investigation. Princeton University, accessed on 1/7/2015 at: https://www.princeton.edu/~mwatson/papers/Presidents_Blinder_Watson_Nov2013.pdf5 Source: https://www.federalreserve.gov/newsevents/press/monetary/20161214a.htm

(continued)


Market RecapAs measured by the Russell US index series, small cap stocks had their highest year of performance relative to large caps since the post-financial crisis bounce of 2010 — the Russell 2000 Index at 21.3% vs. 12.1% for the Russell 1000® Index. The Russell 2000 Index reeled off its third consecutive quarter relative outperformance versus the Russell 1000 Index, posting a return of 8.8% in the final quarter of the year. Small caps avoided the short-lived but sharp quarterly drops that had dragged down annual returns in 2014 and 2015. Once again the Russell 2000 Index avoided back-to-back years of negative returns which, remarkably, has only happened once in its history (2007 and 2008).

Despite the seemingly rosy picture painted by 2016’s finish, there were signs that investors still wanted to position themselves cautiously — particularly among small cap stocks. For the fourth quarter, the Russell 2000® Defensive Index returned +13.2 as compared to +4.6% for the Russell 2000® Dynamic Index. Defensive stocks are those that exhibit a mix of high quality and low volatility, while dynamic stocks tend to be tied to cyclical factors in their underlying industries and the economy overall. The fourth quarter return for the Russell 2000 Defensive Index was the largest since the Russell Stability Index Series was launched in 2011. The Russell 2000® Value Index returned +14.1% as compared to +3.6% for the Russell 2000® Growth Index; the highest return for small cap value since the fourth quarter of 2011. This combination of performance for defensive and value suggests that investors did not merely want additional risk via small caps. Instead, they wanted a mix of “cheap and good.”6.

Large cap stocks, as measured by the Russell 1000 Index, returned +3.8% for the fourth quarter. The Russell 1000 Index ended the year up +12.1%. Mega caps as measured by the Russell Top 200 Index did somewhat better for the quarter, returning +4.1%, but lagged for the calendar year return +11.3%.

Figure 4: Annual returns for the Russell 2000 Index and the Russell 1000 Index historically

-4079 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 11 12 13 16151406 07 08 09 10

-30

-20

-10

0

10

20

To

tal r

etur

n (%

)

30

40

50

Russell 2000® Index Russell 1000® Index

Source: FTSE Russell as of December 31, 2015. Certain results shown reflect hypothetical historical performance. Past performance is no guarantee of future results. Please see important legal disclosures at the end of this report.

6 This type of investment philosophy was first popularized by Benjamin Graham, and later Warren Buffet.


(continued)


Directionally consistent The Russell 2000 Index ticked-off an impressive 15 consecutive days of positive returns between November 4th and November 25th. This stretch included all three days with returns above 2% for the fourth quarter. There were 34 advancing days in the fourth quarter against 29 declining days. The worst single day decline for the Russell 2000 Index was -1.3%.

US economy humming along According to both the US Federal Reserve (“the Fed”) and US Bureau of Economic Analysis (BEA), the US economy continues to record robust growth. The BEA reported that third quarter GDP growth was approximately 3.5%, which was up from 1.4% in the second quarter. The quarter-over-quarter acceleration was attributed to increases in personal consumption and government spending.7 Unemployment remained historically low at 4.7%8, and US home values increased by an estimated 6.5% in 2016 according to Zillow.9

Through November 2016, inflation was 1.7%, based on the Fed’s core personal consumption expenditures index. Inflation is now in-line with the 10-year average of 1.6% but beneath the Fed’s long-range target of 2.0%. At 1.4%, the total personal consumption expenditures index, which includes spending on energy and food, approached its 10-year average of 1.6% as energy prices normalized in the second half of 2016.10

Bottom lineBy almost all measures 2016 was a strong year for the US market. We wrote at the end of 2015, “The 2016 Presidential Election will be entertaining, but probably not hugely impactful on stock market returns over time.”11 The entertainment value may be debatable, but the short term impact of the “election dividend” seems undeniable. However, research suggests that shocks emanating from outside the administration are more likely to shape the Trump economy over the longer term — though the new president is known for breaking convention. n


7 Source: http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm8 Source: https://www.bls.gov/news.release/empsit.nr0.htm9 Through November 2016: http://www.zillow.com/home-values/10 Source: http://www.frbsf.org/economic-research/indicators-data/pce-personal-consumption-expenditure-price-index-pcepi/11 Small Cap Perspectives. December 2015. file:///C:/Users/emontgom/Downloads/4q15_small_cap_perspectives_-_russell_2000%20(2).pdf


Size • Risk was in demand in the fourth quarter and for much of the year. All size and

style segments had positive fourth quarter returns, but small and micro cap stocks were favored during the second half of the year. The Russell 2000 Index of small cap stocks outpaced the Russell 1000 Index of large cap stocks by 5 percentage points in both the third and fourth quarters. Moving to the farthest ends of the market cap spectrum, the Russell Microcap® Index outgained the Russell Top 200® Index of mega cap stocks by 7.4 percentage points in the third quarter and 6 percentage points in the fourth quarter (see Exhibit 1).

• It was a sprint to the finish for small caps as the second half of 2016 propelled the Russell 2000 Index to a size-segment annual return high of 21.3%. The Russell Midcap® Index followed with a 13.8% return and the Russell 1000 Index followed with a 12.1% return.

Style • Value stocks continued to be in favor during the fourth quarter — a trend for

the year overall. The Russell 2000 Growth Index, at +3.6%, significantly lagged the Russell 2000 Value Index (+14.1%) by 10.5 percentage points. The return difference between Growth and Value styles was substantial in the large cap space as well at 5.7 percentage points (see Exhibit 2).

• The market was not as consistent in its treatment of defensive and dynamic companies. Performance of cyclical stocks swung in and out of favor quarter-by-quarter. The Russell 2000 Dynamic Index returned +15.1% but still lagged the Russell 2000 Defensive Index which returned 26.9% for the year. A more muted and opposite result occurred in the large cap space with the Russell 1000® Defensive Index gaining 10% to the Russell 1000® Dynamic Index’s 13.7%.

• For the full year value was the preferred style. The Russell 2000 Value Index (+31.7%), the Russell Microcap® Value Index (+20%), and the Russell 1000 Value Index (+17.3%) were the best performing style segments. By comparison, the Russell 2000 Growth Index returned +11.3%, the Russell Microcap® Growth Index returned +6.9% and the Russell 1000® Growth Index +12.1%.

FTSE Russell considers style along three dimensions: size, valuation and stability. The size dimension includes large cap and small cap as defined by market capitalization. Valuation includes growth and value measures. Stability provides a risk dimension to style by assessing a variety of factors related to quality and volatility exposures. Stability includes dynamic (companies with greater economic sensitivity and more variable earnings profiles) and defensive (companies with less economic sensitivity and more stable earnings profiles). For more information on Russell’s style definitions, please refer to the complete methodology document: Russell US Equity Indexes available at ftserussell.com.

Exhibit 1: Market Cap PerformanceTotal Return (%) (as of 12/31/2016)

20164th qtr

20163rd qtr

2016 2nd qtr

2016 1st qtr

12 Mos Full Year

2016

Russell Microcap® Index 10.0 11.3 4.0 -5.4 20.4

Russell 2000® Index 8.8 9.0 3.8 -1.5 21.3

Russell 3000® Index 4.2 4.4 2.6 1.0 12.7

Russell Top 200® Index 4.1 3.8 2.3 0.7 11.3

Russell 1000® Index 3.8 4.0 2.5 1.2 12.1

Russell Midcap® Index 3.2 4.5 3.2 2.2 13.8

Exhibit 2: Style PerformanceTotal Return (%) (as of 12/31/2016)

20164th qtr

20163rd qtr

2016 2nd qtr

2016 1st qtr

12 Mos Full Year

2016

Russell 1000 Growth Index 1.0 4.6 0.6 0.7 12.1

Russell 1000 Value Index 6.7 3.5 4.6 1.6 17.3

Russell 2000 Growth Index 3.6 9.2 3.2 -4.7 11.3

Russell 2000 Value Index 14.1 8.9 4.3 1.7 31.7

Russell 1000 Defensive Index 2.2 0.6 3.3 3.7 10.0

Russell 1000 Dynamic Index 5.4 7.6 1.8 -1.5 13.7

Russell 2000 Defensive Index 13.2 5.3 3.8 2.6 26.9

Russell 2000 Dynamic Index 4.6 12.9 3.9 -6.2 15.1

Source: FTSE Russell, data as of December 31, 2016. Past performance is no guarantee of future results. Please see important legal disclosures at the end of this report.

Market performance


Small cap performance analysis

• The fourth quarter was directionally positive for the Russell 2000 Index . November had three days with gains in excess of 2% and also held the longest streak of consecutive positive days (15). Early October saw the worst daily return (-1.8%). Positive days averaged a return of 0.84% with a standard deviation of 0.74%; the negative days averaged a return of -0.74% and a standard deviation of 0.48%. Of the 63 trading days in the quarter, the Russell 2000 Index was split 34/29 between up days and down days.

• Small cap stocks extended their third quarter gains and moved higher in the fourth quarter, distancing themselves from large caps. The Russell 2000 Index was up in three of four quarters for the year and up +21.3% overall.

• On a cumulative basis, the Russell 2000 Index has advanced 295.4% since the financial crisis trough on March 9, 2009, and finished 2016 up an additional 7.1% since its previous peak in June 2015 (see Exhibit 5).

RUSSELL 2000 INDEX RUSSELL 1000 INDEX

-60

-40

-20

0

20

40

60

80%

Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Jun-

07

Jan-

0 7

Dec

-07

Jun-

08

Dec

-08

Jun-

09

Dec

-09

Jun-

10

Dec

-10

Jun-

11

Dec

-11

Jun-

12

Dec

-12

Jun-

13

Dec

-13

Jun-

14

Dec

-14

Jun-

15

Dec

-15

Jun-

16

Dec

-16

Exhibit 3: 12-Month Rolling ReturnsTotal Return (%) — 10 Years (as of 12/31/2016)

Annualized

4th Qtr 2016 1 Yr 3 Yr 5 Yr 10 Yr 2011 2012 2013 2014 2015

Russell 2000 Index 8.8 21.3 21.3 6.7 14.5 7.1 -4.2 16.4 38.8 4.9 -4.4

Russell 1000 Index 3.8 12.1 12.1 8.6 14.7 7.1 1.5 16.4 33.1 13.2 0.9

Exhibit 6: PerformanceTotal Return (%) (as of 12/31/2016)

Exhibit 5: Russell 2000 Index Price Performance(January 2007 – December 2016) Total Return

Recent Peak to Peak 06/23/2015–12/09/2016

7.1%


Total Return Pre Recession Peak

to Current Peak 07/13/2007–

12/09/16 +62.2%

2,000

2,200

2,400

2,600

2,800

3,000

3,200

3,600

3,400

Dec

-12

Mar

-13

Jun-

13

Sep-

13

Dec

-13

Mar

-14

Jun-

14

Sep-

14

Dec

-14

Mar

-15

Jun-

15

Sep-

15

Dec

-15

Mar

-16

Jun-

16

Sep-

16

Dec

-16

Exhibit 4: Russell 2000 Index Price PerformanceTotal Return (January 2013 – December 2016)

2014 +4.9%

2015 -4.4%

2016 21.3%

2013 +38.8%

Total ReturnTrough to Present

03/09/2009–12/31/2016 +295.4 %


Relative returns analysis

• Small caps drew even with large caps using a 10-year growth of a unit return (+7.1%). Large caps maintained leads in the three and five year annualized numbers due to stronger relative performance in 2014 and 2015. (see Exhibit 6).

• The size plus style matrix shows the clear preference for value and small cap in 2016. The Russell 2000 Value Index was the highest performing style segment in the fourth quarter (+14.1%) and for all of 2016 (+31.7%). The growth style was still positive for the year and the fourth quarter across all cap tiers, but the Russell 2000 Growth Index lagged its value counterpart by 20.4 percentage points (see Exhibit 9)!


Exhibit 9: Russell Index Style PerformanceTotal Return (%) (as of 12/31/2016)

Index 2016 2015 2014 2013

Russell 2000 Value Index 31.7 -7.5 4.2 34.5

Russell 2000 Index 21.3 -4.4 4.9 38.8

Russell Midcap Value Index 20.0 -4.8 14.8 33.5

Russell 1000 Value Index 17.3 -3.8 13.5 32.5

Russell Midcap Index 13.8 -2.4 13.2 34.8

Russell 1000 Index 12.1 0.9 13.2 33.1

Russell 2000 Growth Index 11.3 -1.4 5.6 43.3

Russell Midcap Growth Index 7.3 -0.2 11.9 35.7

Russell 1000 Growth Index 7.1 5.7 13.1 33.5

0

50

100

150

200

250

Dec

-06

Jun-

07

Dec

-07

Jun-

08

Dec

-08

Jun-

09

Dec

-09

Jun-

10

Dec

-10

Jun-

11

Dec

-11

Jun-

12

Dec

-12

Jun-

13

Dec

-13

Jun-

14

Dec

-14

Jun-

15

Dec

-15


Jun-

16

Dec

-16

Exhibit 8: Performance — Growth of a unitTotal Return (%) — 10 Years (as of 12/31/2016)

2016

Value Core Growth

Large 17.3 12.1 7.1

Mid 20.0 13.8 7.3

Small 31.7 21.3 11.3

2015

Value Core Growth

Large -3.8 0.9 5.7

Mid -4.8 -2.4 -0.2

Small -7.5 -4.4 -1.4

2013

Value Core Growth

Large 32.5 33.1 33.5

Mid 33.5 34.8 35.7

Small 31.7 38.8 43.3

2014

Value Core Growth

Large 13.5 13.2 13.1

Mid 14.8 13.2 11.9

Small 4.2 4.9 5.6

Exhibit 7: Russell Index Style PerformanceTotal Return (%) (as of 12/31/2016)


Risk analysis • Expected volatility for small caps remained below the long term average (26.1)

at an average of 19.2 for the fourth quarter. The CBOE Russell 2000 Volatility Index (RVX) peaked just before the presidential election at 25.4, before subsiding as the dust settled (see Exhibit 10).

• Realized volatility, as measured by the daily returns of the Russell 2000 Index, held steady, with a standard deviation of approximately 0.98% in the fourth quarter (see Exhibit 11). Down days had a standard deviation of 0.47%, and up days a standard deviation of 0.73%.

• The spread in 12-month rolling standard deviation between large caps and small caps continued to widen to a four-year high of 5.1% (see Exhibit 12). The higher volatility among small caps came from stronger upside movement.

Exhibit 10: Implied VolatilityCBOE Russell 2000 Volatility Index (RVX) — 10 Years (as of 12/31/2016)

Exhibit 11: Russell 2000 Index Daily ReturnsTotal Return (%) – 20 Years (as of 12/31/2016)

Standard Deviation (%) Return/Risk Ratio

1 Yr 3 Yr 5 Yr 10 Yr 1 Yr 3 Yr 5 Yr 10 Yr

Russell 2000 Index 18.4 17.1 16.7 26.4 1.2 0.4 0.8 0.3

Russell 1000 Index 13.3 13.5 12.9 21.0 0.9 0.6 1.1 0.3

Exhibit 13: Risk Characteristics Annualized (as of 12/31/2016)

Exhibit 12: 12-Month Rolling Standard Deviation (%)10 Years (as of 12/31/2016)

RVX

Inde

x V

alue

%

-15

-10

-5

0

5

10

15

Dec

-16

Dec

-14

Dec

-12

Dec

-10

Dec

-08

Dec

-06

Dec

-04

Dec

-02

Dec

-00

Dec

-98

Dec

-96

Mar

-96

Dec

-15

Dec

-13

Dec

-11

Dec

-09

Dec

-07

Dec

-05

Dec

-03

Dec

-01

Dec

-99

Dec

-97


0

10

20

30

60

50

40

Dec-16Dec-15Dec-14Dec-13Dec-12Dec-11Dec-10Dec-09Dec-08Dec-07Dec-06

%

0102030405060708090

100


Source: CBOE. CBOE®, Chicago Board Options Exchange®, CBOE Volatility Index®, and VIX® are registered trademarks of Chicago Board Options Exchange, Incorporated (CBOE). RVX is a service mark of CBOE. The Russell 2000 Index is a registered trademark of The Frank Russell Company, used under license. This data is believed to be correct but CBOE does not guarantee the accuracy of the data and will not be held liable for consequences of its use.

Russell 2000 Index10 Yr Avg

+17.8%

9.265

–11.845

10 Yr Average

26.1%



Small cap asset flows

• Small cap ETF assets ended the year by setting another record at $141.5 billion, which bested the third quarter record of $114.5 billion. Mutual fund assets tied to small cap products also set a new record high of $546.3 billion, up approximately $35 billion over Q3 2016 (see Exhibit 15).

• Small cap flows told a different story about how investors choose to ride the incoming tide (see Exhibit 16). Small cap ETFs took in $16.6 billion in net flows for the quarter, while small cap mutual funds saw net outflows of $936.9 million. Small cap mutual fund gains were predominantly driven by market appreciation.

Exhibit 14: Quarterly Small Cap Total Assets ($ billions)10 Years (as of 12/31/2016)

Exhibit 15: Monthly Small Cap Asset Flows ($ billions)Estimated Net Flows — One Year (as of 12/31/2016)

Exhibit 16: Monthly Small Cap Asset Flows ($ billions)Estimated Net Flows — One Year (as of 12/31/2016)

Source: Morningstar Direct. Total assets and estimated net flows are for all US-domiciled open-end mutual funds (excluding money market funds and funds-of-funds) and Exchange Traded Products (ETPs) categorized as small cap, small cap growth or small cap value by Morningstar.

0

100

200

300

400

500

600

700

$

Dec-16Dec-15Dec-14Dec-13Dec-12Dec-11Dec-10Dec-09Dec-08Dec-07

-4

-2

0

2

4

6

8

10

12

Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16

$

Sep-16 Oct-16 Nov-16 Dec-16

Total Small Cap ETF FlowsTotal Small Cap MF flow

-6

-4

-2

0

2

4

6

8

10

12

Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16

$

Sep-16 Oct-16 Nov-16 Dec-16

Source: Morningstar Direct. Total assets and estimated net flows are for all US-domiciled open-end mutual funds (excluding money market funds and fundsof-funds) and Exchange Traded Products (ETPs) categorized as small cap, small cap growth or small cap value by Morningstar.

Source: Morningstar Direct. Total assets and estimated net flows are for all US-domiciled open-end mutual funds (excluding money market funds and funds-of-funds) and Exchange Traded Products (ETPs) categorized as small cap, small cap growth or small cap value by Morningstar.



10

20

30

40

50

60

70

80

90

100%

Energy

Financial Services

Consumer Discretionary

Materials & Processing

Producer Durables

Health Care

Utilities

Technology

Consumer Staples

Russell 2000 Index sector weights

• As explored previously, Financial Services’ performance in the fourth quarter translated to a 2.2 percentage point gain in sector weight over the fourth quarter (see Exhibit 17). The fourth quarter jump contributed to the full year shift of approximately +1.8 percentage points. The Producer Durables and Materials & Processing sectors also saw gains for the quarter (0.34 and 0.30 percentage points respectively), as well as for the year (1.81 and 1.84 percentage points respectively).

• The Russell 2000 Index Health Care Sector continued to take on water as the once high-flying sector declined by 1.97 percentage points over the fourth quarter and 4.32 percentage points for 2016. Our second quarter 2015 Small Cap Perspectives report explored the drivers for growth in the Health Care Sector. It may be that stretched valuations, higher borrowing rates, and uncertainty over future policy support created significant headwinds for the sector in 2016.

Exhibit 17: Historical Sector Weightings (%)10 Years (as of 12/30/2016)

Exhibit 18: Current Sector Weightings (%)as of 12/31/2016


Health Care

Technology

Producer Durables


Financial Services2.6%3.5%

4.6%

7.5%

12.1%

13.3%

13.8%

14.2%

28.4%

Consumer Staples

Utilities

Energy



Russell 2000 Index sector attribution analysis • No surprise that the Financial Services sector contributed a hefty +4.5

percentage points to the return of Russell 2000 Index, followed by Producer Durables (+1.6 percentage points) and Consumer Discretionary (+1.0 percentage points). The out-of-favor Health Care sector (-0.9 percentage points) was the only drag on the Russell 2000 Index for the quarter (see Exhibit 19).

• By industry, Banks (+3 percentage points) were the top contributor for the fourth quarter. Banks made up two-thirds of the Financial Services sector’s contribution to the Russell 2000 Index (see Exhibit 20).

• Health Care related industries detracted most from the Russell 2000 Indexes’ return. Biotechnology and Pharma subtracted approximately 0.8 percentage points from the return of the Russell 2000 Index (Exhibit 21).

• The Financial Services sector had the highest total return (+16.9%) for the fourth quarter. Energy was also a standout, returning 16.4% but only contributing a gain of 0.5 percentage points because its index weight has been impaired by weakness in the sector over the last several years (see Exhibit 22).

Exhibit 19: Sector Contribution to Return (%)Fourth Quarter 2016 (as of 12/31/2016)

Exhibit 20: Top Industry Contributors (%)Fourth Quarter 2016 (as of 12/31/2016)

Exhibit 21: Bottom Industry Contributors (%)Biggest detractors – Fourth Quarter 2016 (as of 12/31/2016)

-1.5-1.0-0.5

0.00.51.01.52.02.53.03.54.04.55.05.5

Utilities ConsumerStaples

EnergyMaterials &Processing

ConsumerDiscretionary

ProducerDurables

Health CareFinancialServices

Technology

%

Insurance:Property-Casualty

RestaurantsBanks: Savings/Thrifts & Mortgage Lend

Semiconductors &Components

Banks: Diversified

%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

%

Biotechnology Pharmaceuticals Equity REIT:Health Care

Equity REIT:Retail

Health CareFacilities


Financial Services

TechnologyProducer Durables


Health Care


Utilities EnergyConsumer

Staples

Russell 2000 Index Weight (%) 28.4% 14.2% 13.8% 13.3% 12.1% 7.5% 4.6% 3.5% 2.6%

Total Return (%) 16.9 5.6 11.5 7.1 -5.7 11.8 6.6 16.4 5.6

Contribution to Return (%) 4.5 0.8 1.6 1.0 -0.9 0.9 0.3 0.5 0.1

Exhibit 22: Sector ReviewFourth Quarter 2016 (as of 12/31/2016)


Russell 2000 Index fundamental characteristics • The valuation of the Russell 2000 Index finished 2016 at 29.4, based on the

index’s price-to-earnings ratio (P/E). A protectionist slant to President Trump’s economic policies may continue to benefit small caps, which are historically more closely tied to the US market (see Exhibit 23).

• Profitability, as measured by five-year return on assets (ROA), trended down during the year from near 5% to 4.23% at the end of the fourth quarter (see Exhibit 24).

• Forecasted earnings growth for companies in the Russell 2000 Index, as measured by five-year forecasted earnings growth, modulated during 2016, hovering between 7.5% –8% before falling to 6.9% at the end of 2016 (see Exhibit 25).

Exhibit 23: Price-to-earnings Ratio (P/E)I/B/E/S 1-year forecasted – Last 9 months as of 12/31/2016

Exhibit 24: Return on Assets (ROA)Trailing 5 Years (%) – Last 9 months as of 12/31/2016

Exhibit 25: Earnings GrowthI/B/E/S 5-year forecasted EPS – Last 9 months as of 12/31/2016

20

2222.64

23.5223.89

25.2626.03

26.36

25.30

28.77

28.77

29.45

24

26

28

30

Sep-16 Oct-16

Oct-16

Nov-16 Dec-16Aug-16Jul-16Jun-16May-16Apr-16

Valuation Growth Quality

P/E – I/B/E/S 1 Yr Forecasted

Price/Book Price/Cash FlowSales per Share Growth – 5 Yr

Long Term Forecasted Growth – I/B/E/S Median

ROA - 5 Yr Avg Debt/Equity Dividend Yield

Russell 2000 Index 29.45 2.29 12.89 4.58 6.90 4.23 0.74 1.40

Russell 1000 Index 18.28 2.91 11.70 5.23 9.90 9.38 0.89 2.03

Exhibit 26: Fundamental CharacteristicsMarket Snapshot (as of 12/31/2016)

2

4

6

4.95 4.91

4.45 4.42

4.40

4.23 4.30

4.35

4.23

8%

Sep-16 Oct-16 Nov-16 Dec-16Aug-16Jul-16Jun-16May-16Apr-164

6

87.68

7.83

7.507.55

7.59

7.79 7.70

7.056.90

10

Sep-16 Oct-16 Nov-16 Dec-16Aug-16Jul-16Jun-16May-16Apr-16



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