2025 Q1 Small Cap Factor Review

Volatility starts off on a negative foot; Size leads in Q1

All data in this post relates to the Jackson Creek small cap universe of stocks.

Size was the leading factor in the small cap universe in the first quarter. The largest ten percent of stocks, ranked by capitalization, outperformed the smallest ten percent by 10.5%, on average. During the market’s uncertainty, larger stocks were favored and viewed as more conservative in light of the Russell 2000’s decline (-9.48%). (Read: Quarterly Market Overview – Q1 2025). The Size factor has less of an influence over the broad small cap index relative to its influence in the large universe. This is due to less concentration among the largest stocks, unlike in the Russell 1000 where a small number of stocks can dictate the index’s return.

Low Volatility was a main factor driving performance in the first quarter. Volatility had the largest absolute spread with a return of -17.6%. This means the difference between the average stock return of the top ten percent of stocks ranked by Volatility and the average return of stocks in the bottom ten percent was 17.6%. During the overall market’s volatile quarter, investors favored stocks with lower Volatility.

Short-term momentum (STM) declined by 10.6%. Recent winners tended to reverse trend and underperform. This is not unexpected when there is broader uncertainty and shifting market conditions. What worked in the recent past was not an indication of future positive performance amid investor sentiment that was tied to fluctuating headlines.

Value had a strong quarter. The most attractively valued stocks outperformed the least attractive by 10.5%, on average. Companies with higher cash flows relative to their stock prices held up better during the overall market decline. Value and Volatility experienced diverging returns, which is common due to their inverse relationship (more below).

Medium-term momentum (MTM) declined 2.44%. MTM had the smallest return among our five key factors. This is the opposite of Q1 2024 (read: 2024 Q1 Small Cap Factor Review)

Factor Returns - First Quarter 2025

The following chart plots the daily cumulative returns for each factor during the first quarter from 2019 through 2025. Contrary to the past few years, factor returns stayed within a tight band until after the midpoint of the quarter. Cumulative returns were within +/- 5% until the tariff-driven volatility picked up and market returns became more volatile. The Volatility factor’s cumulative return started in positive territory and was flat at the midpoint before turning negative during the second half of the quarter. Value, unsurprisingly, followed an inverse path, almost mirroring Volatility’s returns.

Cumulative Daily Factor Returns 2019-2025 - Q1

There were some interesting correlations in the first quarter of 2025 relative to longer-term correlations. We have said above, and in previous posts (read: 2024 FY & Q4 Small Cap Factor Review), that Value and Volatility are inversely correlated. This was especially true in Q1. During the first three months, the two factors had a correlation coefficient of -.94. They were almost perfectly negatively correlated. This compares to their long-term correlation of about -.40. Three months is a small sample size and by no means should be construed as a long-term trend.

Also noteworthy is the large directional change in correlation between MTM and Volatility during the short-term versus their long-term relationship. MTM and Volatility have about a -.39 long-term correlation. During the first quarter, their correlation was .63. So, for two factors that are generally inversely correlated, they had a strong positive correlation in Q1.

2025 Factor Correlations

The large drop in Volatility during Q1 makes it the most negative start to a year in the past 26 years. The -17.6% spread just edges out last year’s first quarter return of -15.7% and the -15.5% return in Q1 2020. Interestingly, 2020 and 2024 turned out to be two very different years for Volatility. In 2020, Volatility produced the highest calendar year return in our 26-year lookback window. Last year Volatility stayed negative and had the fifth most negative year year since 2000.

Volatility Annual Returns

To make the above chart easier to understand, below is a table of each year's first quarter and calendar year returns since 2000. There were only a handful of years where Volatility started out positively. Only one of those years - 2019 - did it end positive (barely). As the table highlights, there have only been six years where Volatility had a positive annual return and three of those were less than 1%. The other three were very strong and, anecdotally, seem abnormal for the factor. The second worst start to a year was in 2020 (-15.90%). That turned out to be the best calendar year return for Volatility. Does that mean this year will mean strong positive returns? Predicting factor returns is not in our wheelhouse.

Volatility Returns - Q1 & Full Year

Next quarter we can see if Volatility is trending similar to past years or if a new pattern emerges.