Does the Small-Cap Premium Exist?

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. 

Valuation Matters
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 Value (DFSVX) (0.52% expense ratio) and  Vanguard Small-Cap Value ETF (VBR) (0.10% expense ratio) might be worth considering. 

But All Is Not Lost
Even if a broad portfolio of small-cap stocks won't reliably outperform large-cap stocks, it still can offer good diversification benefits, particularly in the international arena. Small-cap stocks tend to be more highly leveraged to the domestic economy than large-cap stocks. As a result, foreign small-cap stocks tend to have lower correlations with U.S. stocks than their large-cap counterparts. For example, during the past decade, the MSCI ACWI ex USA Index was 0.89 correlated with the Russell 1000 Index, while the corresponding figure for the MSCI ACWI ex USA Small Cap Index was slightly lower at 0.85.  Vanguard FTSE All-World ex-US Small-Cap ETF (VSS) (0.25% expense ratio) offers low-cost exposure to foreign small-cap stocks from 46 developed and emerging markets.

Investors still may be able to capture an illiquidity premium from micro-cap stocks. However, index funds are poor vehicles to get exposure to these stocks because they usually screen out the most illiquid securities, which may offer higher expected returns than more-liquid stocks. Index funds may also incur high market-impact costs of trading when they rebalance, because they often have to pay a premium to obtain the necessary liquidity to quickly execute trades. (Samuel Lee's article "Micro-Cap ETFs: Still Bad" in the March 2013 Morningstar ETFInvestor newsletter explains these challenges in more depth.)

 DFA US Micro Cap (DFSCX) (0.52% expense ratio) offers a better model. It provides broad exposure to U.S. micro-cap stocks, which DFA defines as the smallest 5% of the market by market capitalization. Yet, because it does not track an index, the fund is not forced to trade when doing so would not be cost-effective. The fund's traders often act as liquidity providers in thinly traded stocks--buying when the herd is selling or selling to satisfy demand--which allows them to obtain better transaction prices. Consequently, this fund offers investors a cost-efficient way to harness an illiquidity premium. 

1) Amihud, Yakov. 2002. "Illiquidity and Stock Returns: Cross-Section and Time-Series Effects." Journal of Financial Markets, vol. 5, no.1 (January): 31-56.

2) Banz, Rolf W. 1981. "The Relationship Between Return and Market Value of Common Stocks." Journal of Financial Economics, vol. 9, no. 1 (March): 3-18.

3) Crain, Michael A. 2011. "A Literature Review of the Size Effect." SSRN Working Papers. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1710076

4) Easterday, Kathryn E., Sen, Pradyot K. and Stephan, Jens A. 2009. "The Persistence of the small Firm/January Effect: Is It Consistent With Investors' Learning and Arbitrage Efforts?" The Quarterly Review of Economics and Finance, vol. 49, no. 3 (August): 1172-1193.

5) Fama, Eugene F. and French, Kenneth R. 2008. "Dissecting Anomalies." The Journal of Finance, vol. 63, no. 4: 1653-1678.

6) Horowitz, Joel L., Loughran, Tim and Savin, N. E. 2000. "The Disappearing Size Effect." Research in Economics, vol. 54, no. 1: 83-100.

7) Keim, Donald B. 1983. "Size-Related Anomalies and Stock Return Seasonality: Further Empirical Evidence." Journal of Financial Economics, vol. 12, no. 1 (June): 13-32.

8) Liu, Weimin. 2006. "A Liquidity-Augmented Capital Asset Pricing Model." Journal of Financial Economics, vol. 82, no. 3 (December): 631-671.

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