It is unreliable at best.
It is intuitive to presume that small-cap stocks should outperform their large-cap counterparts over the long run. After all, small caps do tend to have more limited financial resources, weaker competitive advantages (if any), and lower profitability than large caps. They also tend to be more volatile and have less analyst coverage--which may increase the risk of mispricing. An efficient market should compensate investors for accepting greater non-diversifiable risk with higher expected returns. Consistent with this view, United States small-cap stocks historically have outpaced their large-cap counterparts over the long term. Rolf Banz from the University of Chicago first published this finding in 1981, and it served as the foundation for Dimensional Fund Advisors' first equity fund when the firm was founded later that year. However, since the early 1980s, the small-cap premium has diminished despite outperformance during the past decade. Even if the premium still exists, it is unreliable at best. Investors should not count on a small-cap tilt as a way to boost long-term performance.
From 1927 through 1981, U.S. small-cap stocks outperformed large caps by 3.1% annualized, according to the Fama-French "Small Minus Big" factor. But this performance was uneven. In fact, much of this premium was concentrated in the month of January (Keim, Horowitz, and Easterday). This uneven performance suggests that the market is not offering a consistent risk premium for small-cap stocks. It's also hard to argue that small caps are riskier at the beginning of the year. As an alternative explanation, some researchers have suggested that small caps may experience greater tax-loss selling in December because they include a disproportionate number of stocks that have declined in value (Crain). In January, when this selling pressure subsides, small caps are poised for greater gains, or so the argument goes. However, arbitrage should eliminate this effect, at least in the more liquid stocks. Small caps' inconsistent performance edge over time further undermines the view that they offer a reliable risk premium. As the chart below illustrates, they have underperformed their large-cap counterparts for decade-long spans, such as during the 1950s and 1980s. That's a long time to wait.
Source: French Data Library.
In the periods when small caps did outperform large caps, the illiquid micro-cap stocks included in the group drove a significant portion of the performance gap (Horowitz, Fama, and French). This suggests that the small-cap premium may actually be compensation for liquidity risk. A few studies have presented direct evidence that liquidity risk helped explain the small-cap premium (Amihud and Liu). But small-cap stocks are more liquid than they used to be, partially because the proliferation of small-cap funds has made these securities more accessible. That may explain why the U.S. small-cap premium declined to 1.02% annualized from 1982 through November 2013. During that time period, this premium was not statistically significant, meaning that it may not really exist. Investors may have a tough time capturing what's left of the small-cap premium because most small-cap stock funds invest in fairly liquid securities. For instance, from its inception in December 1978 through 2013, the Russell 2000 Index generated a nearly identical annualized return (12.1%) as the Russell 1000 and S&P 500 Indexes (12%).
There is also no evidence of a small-cap premium in many foreign markets during the past two decades. Small-cap stocks actually underperformed their large-cap counterparts in Europe, Japan, and Asia ex-Japan, from July 1990 through November 2013, based on the Fama-French "Small Minus Big" factor. This illustrates that small market capitalization is not a reliable source of higher expected returns, even over long horizons.
Valuations ultimately determine the long-term performance of small caps relative to larger stocks. In January 2004, the stocks in the Russell 2000 Index were trading at a lower price/forward earnings multiple (16.9) than those in the Russell 1000 Index (18.6). They subsequently generated higher returns over the next decade. However, these stocks are now trading at a premium (19.7 times forward earnings) to those in the Russell 1000 Index (16.2). Consequently, they are less likely to outperform going forward. Differences in expected growth rates can influence the valuation gap between large- and small-cap stocks.
In some cases, lofty growth expectations can work against small-cap stocks. Small-cap growth stocks have actually underperformed their large-cap counterparts over the long term, as illustrated in the table below. These stocks resemble lottery tickets. Some will offer big payoffs, but most won't. On average, investors overpay for these stocks, leading to mediocre returns. However, small-value stocks have a better record relative to their large-cap counterparts. The value premium historically has been greatest among small-cap stocks. Consequently, a small-cap value fund may offer investors a better chance of boosting returns over the long run than a broad small-cap fund. Within this category, Gold-rated DFA US Small Cap ValueDFSVX (0.52% expense ratio) and Vanguard Small-Cap Value ETF VBR (0.10% expense ratio) might be worth considering.