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Big Value in Small Stocks via RILA

If you thought January 2009 was bad, when the S&P 500 fell 8.6%, this January is worse yet. If it holds, it will be the worst January on record for large stocks.

Small caps have had it worse going back to last year, and briefly hit bear market territory this week, having hit their peak in November. But for those willing to hold their nose and give them a go, small caps provide intriguing relative values and diversification to a portfolio.

According to a Bank of America analyst in a recent article, the relative forward PE of the Russell 2000 compared to the Russell 1000 currently stands at 0.75x, its lowest since 2001 and 25% below its long-term average of 1.02x.

Small caps are by nature more volatile than large stocks and hence the reticence for many investors to invest in small companies. Enter the RILA, which allows clients to get exposure to small cap growth potential with a substantial degree of protection.

For example, one issuing company offers a Russell 2000 indexed account with a 45% cap over three years, and a 20% buffer. That strikes me as a heck of a risk/reward deal; let's review in more detail:

  • If the price return index exceeds 45% in return at the end of three years, the contract will be credited with 45%.

  • If the index performance is between 0-45%, the contract will be credited with whatever the performance was.

  • If the index performance is negative at the end of those three years, the contract's buffer will absorb the first 20% of losses.

Put it all together and this seems like an extraordinary bargain in terms of outstanding risk/reward:

  • An upside potential over three years of up to 13.2% per year in compounded growth.

  • An entry point now that is almost 20% below all-time highs two months ago.

  • Not only does a buy today get a 20% discount from a couple months ago but is further protected from another 20% of decline at the end of three years from now which seems pretty remote.

Putting money to work now in small caps and using the RILA for that allocation seems like a timely idea and a much more productive use of capital than sitting scared in cash watching inflation erode its value.

The next question is where to find the money? One place to look is to reallocate some of the surplus gains from large cap stocks over the last decade. For more on that topic, see my article here.

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