Small-cap stocks are riskier than recent history suggests.
The article was published in the August issue of Morningstar ETF Investor. Download a complimentary copy of ETF Investor by visiting the website.
U.S. small-cap stocks have provided wonderful returns since the turn of the millennium. From January 2001 through June 2017 the MSCI USA Small-Cap Index rewarded investors with a 3.9% annualized excess return over the standard MSCI USA Index, albeit with greater volatility. Thus the risk/reward relationship, as expressed through annualized returns and standard deviations, held up fairly well. But these past 16 years exposed a wrinkle in the risk/reward relationship of foreign small-cap stocks. The excess returns were there, but the risk of these stocks, as measured by standard deviation, was similar to that of large-cap stocks—an unexpected outcome to say the least. A closer look at the behavior of foreign small-caps over this span shows that they were indeed risky, but standard deviation may not have fully captured that risk.
Why do we expect small-cap stocks to be riskier than large-caps? For one, small companies tend to lack the global scale of their large-cap counterparts, with a large portion of their revenue coming from their local economy. This is true both in the U.S. and abroad, and makes these firms more susceptible to local economic conditions and policies. They are less likely to have competitive advantages than larger companies. In general, small-caps should be more volatile than large-caps, and may provide a higher rate of return as compensation.
It would be easy to assume that what has been observed in the U.S. also holds up in other markets around the world. But simply assuming that U.S. market characteristics also occur in other markets can make for poor investment policy, especially when global indexes are available that allow investors to conduct out-of-sample testing. Confirming that observations hold up in multiple circumstances also improves confidence that the observation has merit, is more likely to persist in the future, and is less likely to be a consequence of data mining. In this instance, I examined foreign stocks over the same time period as U.S. stocks using the MSCI ACWI ex-U.S. Index. The results are compiled in Exhibit 2.
The excess return was clearly there, and similar to that observed in U.S. stocks, at 3.8% annualized. Curiously though, the risk/reward relationship doesn’t appear to hold up as well, as both the standard index (composed of large and midsize stocks) and the small-cap index weighed in with similar volatility. This is an interesting outcome, and not one that would be expected based on the observations of U.S. indexes and the more general risk-reward expectations.
A closer examination of the past 16 years provides some possible explanations for this discrepancy. First and perhaps most obvious, the global economy as a whole experienced a substantial shock during the 2007 to 2009 period, with financial firms being hit particularly hard. Foreign large-cap indexes, such as the MSCI ACWI ex-U.S. Index under examination here, have historically had about 20% of assets allocated to financial firms, while small-cap stocks weighed in at around 10%. This difference sounds like an obvious explanation—a larger helping of volatile financial stocks could indeed make large-caps riskier than small-caps. The problem with this reasoning is that the volatility of foreign small-cap stocks increased substantially relative to large-caps during this period as evidenced by the 36-month rolling volatility shown in Exhibit 3.