Sizing Up Small Caps

A version of this article was published in the August 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website.

Depending on which index provider's definition you rely on, small caps make up anywhere from 3% to 12% of the total investable market capitalization of the U.S. stock market. Looking outside U.S. borders, small caps account for 15% of the MSCI All-Country World ex-U.S. Index. At market weightings, this would amount to an allocation to U.S. small caps of roughly 1%-4% and about 5% to ex-U.S. small caps within a globally diversified, 60/40 stock/bond portfolio. This bit of context is important. Before making a big deal about small-cap stocks, it's imperative to remember that they represent a small slice of global stock markets and just a sliver of the global market portfolio.

Here I'll review the research that stirred investors' interest in the market's smallest names, how it was subsequently all but debunked, and how it was resuscitated (kind of). From there, I'll take a look at the differences in index methodologies across the small-cap benchmarks behind some of the most popular exchange-traded funds in the space. I conclude with my thoughts on what it all means with respect to portfolio construction.

Small Wonders Rolf Banz is widely credited as being the "father of the small-firm effect." In his University of Chicago Ph.D. dissertation, published in 1981, Banz found that smaller stocks generated greater risk-adjusted returns, on average, than larger ones.[1]

Banz's findings were bolstered by many of the risk-based explanations that efficient-markets acolytes hold out as justification for higher risk-adjusted returns. Smaller firms aren't as well-capitalized as their peers, their business lines may be less diversified, their customers may be larger and have more clout over them, and so on. So, the theory goes that they should offer greater returns to compensate investors for the risk they assume.

There are also intuitive institutional factors that could justify a small-cap premium. Fewer analysts cover small-cap stocks. A lack of coverage could lead to informational barriers that may result in mispricing. Moreover, small-cap stocks are less liquid and thus more costly to trade. Scant liquidity could further justify the existence of the small-cap effect as investors should--in theory--be rewarded for the risks associated with illiquidity.

The Small-Firm Effect Shrivels In the decades since Banz published his work, the size premium has been picked apart. Here are the highlights of the takedown:

• It is concentrated in the smallest of the small. It turns out that the size effect gets most of its oomph from micro-caps. The smallest 5%–10% of stocks has dramatically outperformed all other size cohorts. Removing these stocks from consideration causes the size effect to disappear.[2]
• It was based on dodgy data. As it turns out, there were significant biases in the data set Banz used in his work. This isn't entirely surprising, as the publication of his dissertation predated the introduction of Microsoft Excel for the Macintosh by about four years. The specific data issue plaguing his work was related to delistings. The CRSP database Banz used was missing returns for many delisted stocks. These stocks' returns were generally large and negative. Adding back these missing detractors makes the size effect fade away.[3]
• It seems to have been particularly strong in January. Just two years after Banz published his findings, it was shown that half the excess returns of small-cap stocks came during the month of January and that half of the January returns were concentrated in the first five trading days of the new year.[4] This "January effect" has defied attempts at any rational, risk-based explanation. Furthermore, this effect has diminished with time.[5] Its dependence on a seasonal peculiarity that has weakened through the years is another example of the size effect's shaky footing.
• It just hasn't panned out. Most importantly, in practice, small caps simply haven't produced greater risk-adjusted returns versus their large-cap peers. Exhibit 1 is a relative wealth graph. It plots the growth of an investment in the Russell 2000 Index (representing small caps) versus an investment in the Russell 1000 Index (representing large caps). When the line is sloping upward, small stocks are outperforming large ones and vice versa. Since the small-cap effect was documented in the early 1980s, small caps have in aggregate underperformed large caps. While the relationship outlined in the exhibit is decidedly unscientific, many academics have arrived at similar conclusions.[6]

Don't Call It a Comeback More recently, AQR researchers have revived the small-firm effect, albeit in a form quite distinct from the original.[7] Specifically, they found that a significant size premium appears after controlling for stocks' quality. Homing in on quality small-cap stocks (those with solid, consistent profits; clean balance sheets; and responsible investment policies), or inversely, giving the boot to "junk" stocks, brings the size effect back to life. These findings pose interesting challenges to any risk-based explanation for the small-firm effect.

Additionally, while small caps on the whole may not offer an avenue to above-average risk-adjusted returns, they are fertile ground for more-careful farming of a variety of factors--factor exposures tend to be amplified within small caps.

Sizing Up Small-Cap Benchmarks Investors looking for broad-based small-cap exposure have a plethora of options. It can be argued that Banz's dissertation launched a thousand funds in the ensuing decades. It also gave rise to a host of small-cap indexes and funds that track them. Investors in small-cap exchange-traded funds and index funds are spoiled for choice. But this is both a blessing and a burden. As is always the case in selecting among index fund options, index construction matters. Here are some things you should focus on when scrutinizing small-cap benchmarks.

Definitions of "small" vary widely. As I mentioned at the outset, depending on the index family in question, small caps might represent anywhere from 3% to 12% of the investable market capitalization of a given parent index. As shown in Exhibit 2, the S&P Small Cap 600 Index represents about 3% of the market cap of its parent index, while the CRSP U.S. Small Cap Index captures 12%. These differences owe to index design. The CRSP family of indexes uses market-cap-based breakpoints; the small-cap benchmark will always encompass the bottom 2%-15% of the investable universe. The S&P index follows a count-based construction process. It bundles the smallest 600 stocks from its parent index, the S&P Composite 1500 Index. As such, its market cap will fluctuate as a percentage of the market cap of the parent index over time. These nuanced differences will yield distinct risk/reward profiles over time, as shown in Exhibit 3.

Screens matter. The S&P index family is unique in that it employs a "financial viability" screen to stocks being considered for addition to its indexes. To be included in the index, a stock must have four consecutive quarters of positive earnings. This acts as a quality screen of sorts. Thus, it's unsurprising that the funds tied to this benchmark have shown a statistically significant loading on the quality factor and--given what we discussed previously about the effect of screening for quality among small caps--have produced superior long-term risk-adjusted returns relative to their peers. This "edge" underpins our Morningstar Analyst Rating of Gold for iShares Core S&P Small-Cap ETF IJR.

Reconstitution has a price. There is perhaps no greater example of the real costs of reconstitution than the Russell 2000 Index. At the bottom of its portfolio, the index dabbles in illiquid micro-cap names. These stocks are expensive to trade. The index does little to buffer the regular addition and deletion of these names from its portfolio, resulting in meaningful transaction costs. Furthermore, the Russell 2000 Index is the most widely followed of small-cap benchmarks, so its annual reconstitution attracts a lot of attention. The sums of money sloshing into and out of the smallest names in the index further compound the issue. The ill effects are apparent in the index's performance and reflected in our Bronze ratings for iShares Russell 2000 ETF IWM and Vanguard Russell 2000 ETF VTWO.

Implications for Portfolio Construction What does this all mean with regards to small caps' role in your portfolio? First and foremost, small caps are by definition bit players. They're unlikely to juice your returns, unless perhaps if you set out for a more targeted factor exposure. They are most likely to provide some level of diversification benefit, as they are less than perfectly correlated with large and mid-caps. But maximizing these benefits depends in part on how you piece the puzzle together. For example, crossing over between index families can have unintended consequences. The 7% overlap between the portfolios of Vanguard Small-Cap ETF VB and iShares Russell 1000 ETF IWB is a case in point. While the Vanguard fund is one of three Gold-rated ETFs in its Morningstar Category, it's important to remember that these ratings are framed on a peer-group-relative basis. VB is a fine option, but IWM is designed to "complete" IWB. When it comes to building a portfolio, mixing between index families can be like trying to build a spaceship from a mix of Legos and Lincoln Logs. It can be done, but the end result will be suboptimal.

[1] Banz, R.W. 1981. "The Relationship Between Return and Market Value of Common Stocks." J. Financial Economics, Vol. 9, No. 1, P. 3.

[2] Horowitz, J.L., Loughran, T., & Savin, N.E. 2000. "The Disappearing Size Effect." Research in Economics, Vol. 54, No. 1, P. 91. //doi.org/10.1006/reec.1999.0207

[3] Shumway, T., & Warther, V. 1998. "The Delisting Bias in CRSP's NASDAQ Data and Its Implications for the Size Effect." //www-personal.umich.edu/~shumway/papers.dir/nasdbias.pdf

[4] Keim, D.B. 1983. "Size-Related Anomalies and Stock Return Seasonality: Further Empirical Evidence." J. Financial Economics, Vol. 12, No. 1, P. 13.

[5] Easterday, K.E., Sen, P.K., & Stephan, J.A. 2009. "The Persistence of the Small Firm/January Effect: Is It Consistent With Investors' Learning and Arbitrage Efforts?" Quarterly Rev. Economics and Finance, Vol. 49, No. 3, P. 1172.

[6] Crain, M.A. 2011. "A Literature Review of the Size Effect." SSRN Working Paper. //papers.ssrn.com/sol3/papers.cfm?abstract_id=1710076

[7] Asness, C.S., Frazzini, A., Israel, R., Moskowitz, T.J., & Pedersen, L.H. 2015. "Size Matters, If You Control Your Junk." Fama-Miller Working Paper. //ssrn.com/abstract=2553889

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