‘Diversification is your free lunch’ as market dynamics shift, CEO of world’s largest index provider says

• Traders are diversifying their strategies with small caps and defensive sectors having their moment, Dan Draper, chief executive officer at S&P Dow Jones Indices, told CNBC’s “Squawk Box Europe” on Wednesday.
• Investors are looking to buy equal weight rather than buying the market cap-weighted S&P 500 with a concentration, he said.

Diversification into smaller stocks is a “free lunch” for long-term investors as market trends shift, according to the head of the world’s largest index provider.

After a period of concentration into the “Magnificent Seven” mega-cap tech stocks — comparable to the dotcom bubble of the 1990s — traders are diversifying their strategies with small caps and defensive sectors having their moment, Dan Draper, chief executive officer at S&P Dow Jones Indices, told CNBC’s “Squawk Box Europe” on Wednesday.

Investors are looking to buy equal weight rather than buying the market cap-weighted S&P 500 with a concentration, he said. An equal-weight index gives every stock the same weight regardless of size, while a market capitalization-weighted index gives greater weight to those with bigger market values.

“[Equal weight] gives you a tilt toward smaller companies as well as value and more defensive, and building through that. We’ve also seen [a shift] not only in the cash equity market, but derivatives — there’s now a futures contract as well, E-Mini futures contract on the equal weight,” Draper said.

“So now we’re starting to see that diversification … we have seen in July, for example, after the U.S. inflation numbers came out, high outperformance in that month for small cap[s]. You’ve also seen value in some defensive sectors performing well. So that gives you the equal weight opportunity to really diversify away from that concentration.”

Investors in August are navigating whipsawing global stock markets, shifting expectations for Federal Reserve rate cuts amid recession fears, and the unwinding of the Japanese yen carry trade which is reverberating through other assets — all in a month prone to volatility.

“When you look at potential rate cycle changes, U.S., obviously the other direction in Japan, you’re starting to see money in motion. But the mean reversion is really critical,” Draper said.

A mean reversion occurs when assets revert to a long-term historical average following a sharp move.

“If you’re a longer term investor, the diversification is your free lunch, and that ability to get more defensive, or maybe interest rate-sensitive … you’re starting to see those factors which, again, had really lagged,” he said.

Numerous market participants have flagged the potential opportunity in small- to mid-cap stocks as wider market forces shift.

“The odds of a [U.S.] recession have picked up … at that point in time when recession is announced, it’s more often already done and complete, and usually, small-, mid-cap stocks can do well,” Craig Johnson, chief market technician at Piper Sandler, told CNBC’s “Worldwide Exchange” on Thursday.

“I think that would be fitting very well into Fed cuts that are coming in the September time-frame. I think it’s time to take a very hard look at small- and mid-cap stocks,” he added.