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ETF Specialist

Does the Small-Cap Premium Exist?

It is unreliable at best.

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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.

Alex Bryan has a position in the following securities mentioned above: VBR. Find out about Morningstar’s editorial policies.