One of the most popular investment factors is size, or, more specifically, small size.
Research has shown that, in the long run, stocks with a small market capitalisation will outperform those with a large market cap.
Alongside market risk and value, size was one of the three factors in the ground-breaking Three-Factor Model introduced by Gene Fama and Ken French in 1992.
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Transcript:
One of the most popular investment factors is size.
A number of studies have shown that, in the long run, stocks with a small market capitalisation will outperform those with a large market cap.
Alongside market risk and value, size was one of the three factors in the ground-breaking Three-Factor Model introduced by Gene Fama and Ken French in 1992.
The size factor is not without its critics. Some academics have even suggested it’s a statistical fluke. A 2011 study by Elroy Dimson, Paul Marsh and Mike Staunton showed that, and after adjusting for market exposure, the size effect quickly disappears.
But size continues to some extent in most multi-factor strategies.
The question of why small stocks outperform is the subject of heated debate.
There are those who say it’s down to risk; in other words, small stocks tend to be riskier than large stocks, and higher risk generally leads to higher returns. For some, the size premium is primarily a compensation for liquidity risk.
Others prefer behavioural explanations. One argument is that large firms tend to have done better in the past than small firms, and investors are naturally attracted to stocks with a good track record. Another possibility is that investors tend to gravitate towards stocks they’re familiar with, and they’re usually the larger companies.
What about long-term performance? Well, small-cap stocks have generally outperformed their large-cap peers since the mid-1980s.
But over the last ten years, the performance of small- and large-caps has been very similar.
For example, in the ten years up to the end of April 2021, the MSCI ACWI Small Cap Index returned 9.73%. The parent index returned only slightly less — 9.17%.
The MSCI Emerging Markets Small Cap Index returned 3.82%, while its parent index returned 3.59%. Again, not much of a difference.
And what happened to small and large-caps during the coronavirus crisis? Well, small-caps fell even further than large-caps when markets crashed in March 2020. But that changed as markets recovered, and small-caps rallied more than large-caps as the news on Covid-19 vaccines and vaccination programmes improved.
So, let’s compare the MCSI ACWI Small Cap index with the MSCI ACWI global capitalisation index.
A significant difference is the turnover of each index — 16.5% for the small cap index in the 12-month period to the end of April 2021, compared with 4% for the parent index.
On the positive side, the small cap index has a better Sharpe Ratio — 0.43% as opposed to 0.37%. But dividend payouts are lower. The index also has a lower exposure to low-volatility stocks.
You’ll see there’s no crossover in the top ten constituents of each index.
Again, it needs to be stressed that predicting future returns for the different risk factors is extremely difficult.
But it’s worth noting that, in the past, small caps have outperformed during periods of rising inflation expectations. Small companies have also performed better than their larger peers during economic downturns and the early stages of economic expansions.