Do Small Caps Outperform Over Time?
“Small Cap stocks outperform Large Cap stocks over time.”
Many investors accept this statement as a given, without further investigation. The idea that small capitalization stocks outperform their larger counterparts has been around for a while. It was first introduced in the early 1980s (see Banz) and was expanded upon and popularized in the early 1990s (see Fama and French). Going back to 1926, the Fama/French study shows Small Cap outperformance of roughly 3% per year.
Case closed? Far from it.
The Russell 2000 Index is the most commonly referenced U.S. small-cap index and the most common benchmark for small-cap funds. We have data on this index going back to December 1978. Would it surprise you to learn that since the inception of this index through the end of 2015, a thirty-seven year period, it has underperformed the large-cap S&P 500?
That is precisely what we find in observing the table below. From 1979 – 2015, the S&P 500 has produced an annualized return of 11.7% with an annualized volatility of 15.1%. Over the same time period, the Russell 2000 has produced an annualized return of 11.4% with annualized volatility of 19.5%. This stands in contrast to the notion that Small Caps outperform not only in absolute terms but on a risk-adjusted basis as well.
This is not to say that Small Caps have not been a good long-term investment in their own right. They certainly have been on an absolute basis and relative to inflation. But this is not the question.
The question is whether one should be overweight Small Caps with an expectation of long-term, risk-adjusted outperformance. It is hard to make that case based on the last 37 years.
If you modify the start and end date, you can find a Small Cap effect. There have been many years where Small Cap stocks have outperformed Large Caps. The longest consecutive streak in recent years occurred from 1999 – 2004.
But again, the question is not whether Small Caps have had long periods of outperformance versus Large Caps (they certainly have) but rather if there is indeed abnormal returns associated with the asset class. That is a much harder case to make.
In a 2015 paper by Cliff Asness and his colleagues at AQR, they come to a similar conclusion: “The size premium … has a weak historical record, varies significantly over time, in particular, weakening after its discovery in the early 1980s. This is concentrated among microcap stocks, predominantly resides in January. It is not present for measures of size that do not rely on market prices. It is also weak internationally, and is subsumed by proxies for illiquidity.”
They go on to argue that there is, a Small Cap premium, but only if you control for quality. This means that high quality (their definition: profitable businesses that display profit growth, safety and have a high payout) Small Caps outperform Large Caps by a wide margin.
An interesting finding to be sure. But I think it’s safe to assume that most investors who have been overweight Small Caps on the belief that they outperform over time without additional risk have not been “controlling for quality.” Which means that their investment in Small Cap stocks has at times stood in contradiction to the CAPM. Also adding higher volatility to their portfolio with a lower annualized return.
That may or may continue to be the case in the future, but it’s certainly something to consider.
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