“In the business world, the rear view mirror is always clearer than the windshield.” – Warren Buffett
The long debate about the small cap effect
The idea of a premium for investing in smaller companies has been around since at least the early 1980s. The common view is that small companies tend to be riskier (or we perceive them to be) and thus the premium is a compensation for risk. Small cap – even put together as a whole – is indeed more volatile than large/mid cap.
Portfolio construction theory however suggests that only risk that cannot be diversified away demands a premium. In other words, assets are rewarded according to their market beta. For small cap, that beta is – varying with index provider and region – only modestly above one, implying no significant premium versus the overall market. The sector exposure of small cap is in line with this modest beta exposure. Small cap has consistently less weight in the low beta Consumer Staples and Health Care sectors, whilst there is more weight in the high beta Industrials and Consumer Discretionary sectors.
Historical risk premium
Indeed looking at the 38-year history of backfilled indices since 1979, there is not much evidence of this so called small cap effect – leadership has been split fairly evenly, with small cap leading in 20 years and large/mid cap in 18 years. From a testing the small cap effect perspective, small cap exhibited a string of consecutive years of leadership, from 1979 through 1983 in the time before publication of the Russell index. So since actual introduction of the small cap index in 1984, US small cap has actually underperformed the large/mid cap Russell 1000 index by 1.5% annually. Perhaps, the small cap effect is now too well known about, exploitable, to persist anymore?
Advocates would point to recent history as evidence against – Based on five year rolling returns, the MSCI World small cap index has now achieved a 15 year track record of consistently outperforming large/mid cap. However, this outperformance has been moderate and would not change the impression that over time, the small-cap effect is considerably weaker and more sporadic than other effects, such as value and momentum.
Market-Implied Small Cap Premium
Looking forward, you can check to see whether investors are demanding a forward looking “small cap” premium, by looking at how they price small as opposed to large companies and backing out what investors are demanding as expected returns. Simple approaches are earnings or dividend based, considering current level of yield and future growth rates. For both earnings and dividends, small cap has a considerably lower current yield, whilst forward growth rates are now similar. This implies, that the market is actually not pricing in a small cap premium, but a small cap discount. This is in exact opposite to the situation for value, where similar considerations clearly show a priced-in premium.
In the academic world, the small cap premium discussion has entered a new round, as proponents now argue that the interaction of the size factor with other factors is critical when seeking the size premium. Some authors have managed to resurrect a sizeable effect, but accomplish it only by removing the subset of small companies that they classify as “low quality” or “junk”.
While these results are interesting and can be used by active small-cap fund managers as a least partial justification for their activity, those following a broad passive strategy of buying small cap stocks and expecting to be rewarded with a premium for just doing so might be disappointed. Nonetheless, investment portfolios containing active exposure to stock markets will naturally tend away from the large cap space anyway – even in the absence of a widespread small cap premium, stock pickers will understandably focus more on the areas of the market that are less widely covered by the global analyst community. The chances of mispricing or gleaning an informational advantage are simply greater.