Leveraging Quantitative Models to "Cleverly Capture" Micro-Cap Returns

Wind data shows that as of early March, the Wind Micro Cap Stock Index has increased by approximately 80% over the past year. As the index rises, a number of related fund products have delivered impressive performance.

With the index continuing to climb, does this mean that the valuations of small and micro-cap stocks held by these funds are now too high? Wang Ying, Deputy Director of Quantitative Investment at CITIC Prudential Fund and fund manager, offers a different perspective. She believes that the historical levels of the index represent the results of a “buy low, sell high” strategy in the past, and do not directly reflect the current valuation levels of the constituent stock portfolio. Wang Ying argues that the long-term effectiveness of small and micro-cap strategies is driven by their characteristic of having an “uncertain win rate but higher odds.” By continuously capturing “valuation recovery” trading opportunities through disciplined quantitative methods, they can accumulate significant long-term returns. Looking ahead, in an environment of overall ample liquidity and structural market differentiation expectations, this strategy model still has room for sustained operation.

Core Driving Force: “Three lows and one high”

Why has the Wind Micro Cap Stock Index been able to perform strongly over the long term? What is the root cause of its returns? Wang Ying’s answer gets to the essence: it is the combined effect of the A-share market environment and the structure of market participants. She summarizes the core characteristics of small and micro-cap stocks as “three lows and one high.”

“‘Three lows and one high’ means low institutional participation rate, low willingness of existing shareholders to sell, low turnover rate, but high stock price elasticity.” Wang Ying further explains that micro-cap stocks with a market value around 2.5 billion yuan are difficult to enter the core stock pools of mainstream institutional investors, have limited sell-side research coverage, and their trading counterparts are mostly individual clients with diverse behavior patterns. More importantly, for major shareholders, the cost of taking the company public is high. When the market value drops to “shell value,” their primary intention is not to reduce holdings for cashing out, but to improve the company’s fundamentals through second growth curves, asset injections, and other means. This results in lighter overall selling pressure in the sector.

“It is this ‘lightweight’ characteristic that makes these small and micro-cap stocks highly elastic once they attract capital.” Wang Ying says, “The downward space is anchored by their long-term average market value, forming an asymmetric risk-reward structure.”

She emphasizes that understanding the performance of the Wind Micro Cap Stock Index hinges on recognizing its construction rules. The index daily includes the 400 smallest market value stocks in the entire market, and removes stocks that have risen out of the index. “This means that the long-term rise of the index is driven by rules—continuous high selling and buying under a strategy—its historical levels are the accumulation of strategy returns, not a reflection of valuation bubbles in current holdings.” Wang Ying states that this is similar to the logic of dividend and other Smart Beta indices; the index performance reflects the successful execution of the strategy in the past.

Refining returns with quantitative models

Since the index’s returns are clearly sourced, why not directly replicate the index for investment? Wang Ying points out practical obstacles: strict daily rebalancing according to the index would generate extremely high trading and impact costs, eroding most of the gains.

Therefore, her team has chosen a “similar but better” quantitative approach. They draw inspiration from the index, engaging in contrarian trading within the small-cap universe to capture valuation recovery opportunities, but implement this through more refined models and trading management.

“Our core strategy is quantitative stock selection plus dynamic trading.” Wang Ying explains that the team first conducts fundamental screening of listed companies from qualitative and quantitative perspectives to improve the strategy’s win rate. Then, within the stock pool, they build a buy signal model based mainly on price-volume information. “Because for these companies, their short-term volatility is more driven by trading behavior itself.” The model monitors indicators such as turnover rate, volatility, single-order placements/cancellations, and active buy-in amounts. Using this model, they daily select signals from stocks to construct and maintain a highly diversified portfolio.

In execution, the team adopts a “periodic rebalancing combined with intraday adjustments” approach, spreading out the monthly rebalancing pressure of the index across each day. “We make small adjustments daily, which allows us to continuously capture intraday trading opportunities while effectively controlling market impact and trading costs.” Wang Ying says.

High returns inevitably come with high risks. How does the strategy manage risk? Wang Ying states that at the individual stock level, they set absolute valuation thresholds, monitor financial indicators and market sentiment to screen companies’ fundamentals. At the sector level, they focus on trading congestion. “For example, we observe the proportion of trading volume in small and micro-cap stocks relative to the total A-share market. When this ratio is too high, it indicates the sector is carrying liquidity that exceeds its size, and risks are accumulating.”

However, Wang Ying emphasizes that risk management aims to smooth returns and improve the holding experience, not to precisely time and avoid every downturn. “We don’t easily reduce positions to very low levels because the returns of small and micro-cap strategies come from continuous rebalancing trades. Overly worrying about missing out on declines and maintaining low positions long-term would actually sacrifice long-term gains.” She adds that position adjustments are only made when sector congestion is significantly high, with the core principle of “aiming for smooth returns.”

Liquidity amplifier

For investors considering small and micro-cap fund products, Wang Ying offers an analogy: “A股 market liquidity amplifier.”

“The rise and fall of small and micro-cap sectors are highly correlated with the overall market liquidity environment, and their elasticity is even greater.” She explains that when liquidity is abundant and inflows increase, small and micro-cap stocks, with their poor liquidity and light capitalization, amplify upward effects; conversely, during systemic risks and rapid outflows, their declines can be larger than the market average. Additionally, small and micro-cap sectors often show a “seesaw” effect with major market themes (such as popular sectors). When funds flood into a few main themes, small and micro-cap stocks may temporarily lose ground; when the main themes retreat and funds seek new directions, small and micro-cap stocks tend to absorb liquidity and perform actively.

This characteristic endows small and micro-cap strategies with unique asset allocation value. Data shows that the Wind Micro Cap Stock Index has low correlation with mainstream broad indices like the CSI 300, CSI 500, and CSI 1000 (correlation coefficients between 0.7 and 0.8). “This means that including small and micro-cap strategies in a portfolio can effectively reduce overall volatility and improve the investment experience.” Wang Ying believes that, while favoring and allocating to mainline sectors, combining some small and micro-cap strategies with low correlation can help balance the portfolio.

Because of a deep understanding of liquidity’s double-edged nature, Wang Ying’s team places great importance on “protecting product liquidity.” “Currently, we impose strict purchase limits on related products.” She explains that this is not only due to the limited capacity of small and micro-cap stocks, but also to discourage large funds from frequent short-term trading, which could cause net asset value shocks and harm all investors.

Looking ahead, Wang Ying states that in the current A-share market, with ongoing policy support, it is unlikely that we will see the kind of severe, one-sided rapid systemic risk seen in the past. “As long as market liquidity does not experience a long-term structural depletion, the underlying logic of daily trading to accumulate returns for small and micro-cap strategies remains valid.”