Small ones are more juicy is the phrase that comes to mind when thinking about the effect of the size (or small cap) premium on your portfolio. It’s long been contended that smaller companies deliver better returns for investors over time than their bigger brethren, albeit at greater risk.
The size premium is thus one of a quiverful of return premiums that have the potential to arrow you towards your investment targets – or indeed, to give you the shaft.
Each return premium comes with a cortege of risks and controversies. Size is no different.
Reasons for the small cap premium
The underlying explanation for the size premium is that companies with a small market capitalisations (small cap) are inherently riskier propositions than large cap firms. Therefore investors should expect to earn greater returns from investing in tiddlers, or else why would you bother?
In the US, this expectation of a juicier reward has averaged out as a 1.99% annualised premium for small cap firms over large caps between 1927 and 2012.
Evidence for the size premium has been found in most markets outside the US, too.
It’s important to note that the size premium is a reward for taking risk. This means that the small cap rollercoaster is more sickening than the regular stock market ride. You can wait years before the premium shows up, if it does at all.
The risks of small caps are well known:
- Smaller companies tend to be more vulnerable in straitened economic times.
- They find it harder to get credit and are more likely to go bankrupt.
- Weeny firms are more costly to trade – a lower volume of shares means they have wider bid-offer spreads, and it’s harder to liquidate your position without moving the market against you.
Some commentators suggest that the size premium is actually a liquidity premium – compensation earned for investing in illiquid equities.
Does the size premium exist?
Some question whether the size premium actually exists at all.
The arguments swirl around whether the premium has offered superior risk-adjusted returns, whether most of the outperformance occurred during a historical golden age of small-caps, and over whose methodology is right.
Even a small cap proponent like passive investing guru Larry Swedroe
It’s important to know that the size premium is strongest in the small cap value sector of the investing universe.
In other words, you should look for funds that invest in small and unfavoured companies. I’ll look at this in greater detail in my next post.
Larry Swedroe argues that it’s the anomaly of small cap growth companies that drags down the size premium, as wannabe Googles and Amazons blaze across the sky before crashing to Earth.
Investing in small cap value funds is the best way to avoid these small growth companies.
The small print
Regardless of the outcome of that debate, there is no guarantee that a return premium will continue to deliver just because it has done so in the past.
The size premium is widely considered to be the weakest of the set. It managed a 26-year period of underperformance between 1982 and 2008.
Worse still, most of the figures you’ll see bandied around for return premiums don’t take into account the real world bogeymen of expenses and taxes.
Moreover, the small cap and value investing styles have attracted large inflows of investor cash in recent years, as evidenced by the recent smart beta hype.
A more sober estimate of the potential is Rick Ferri’s forecast of a 0.3% annual premium for small cap investments, rising to a 1% premium if you focus on small cap value equities.
Size is no guarantee of satisfaction
Regardless of the eventual triumph of the minimalists – or not – investing in small companies does diversify your portfolio.
If mega caps have a mediocre year then teeny caps may well take the edge off it, as the size factor has a relatively low correlation with the performance of the overall market.
Just remember that investing styles drift in and out of fashion like hemlines. To truly benefit from any size premium, you’ll need the discipline to commit to it over those many years when it seems about as real as the leprechauns.
Take it steady,
The Accumulator
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Great article, more double entendres than Finbarr Saunders!
I’ve invested a little in small co funds, both UK and Global and will continue to do so for diversification.
Why doesn’t Your portfolio contain small and value funds?
http://monevator.monevator.netdna-cdn.com/wp-content/uploads/2014/03/153.-Portfolio-tracker-spreadsheet.png
Gregory
Firstly- hat tip to weenie for the Finbarr Saunders reference.
Second – great article but we have to face the unpleasant possibility that, at certain times, the expected size premium is negative. It depends on the starting point valuations. Small caps can be priced to deliver lower returns relative to large caps, perhaps when risk appetite and investor complacency are high. As you rightly say, this fluctuates over time with fashion. Interestingly, US small caps are currently forecast by GMO as the lowest expected return equity asset class.
https://www.gmo.com/Europe/CMSAttachmentDownload.aspx?target=JUBRxi51IIBtnjt5uucdOPTDOS6iaxprnp3nh4RKMz2vuFFstHPGOQXB76XbDN34ZEN2TMTZCJKoWxPr575%2bQTggND%2b0g25QwvkTUbFNbB3wNZIjDEq%2fNw%3d%3d
They could be wrong of course….
My experience is that small caps go in and out of fashion
Right now they are in fashion, there are a lot of dodgy small cos on the market and lots more dubious IPOs
The future is unknown but small caps heps diversify Your portfolio due to the low correlation with the large ones.
“Regardless of the eventual triumph of the minimalists – or not – investing in small companies does diversify your portfolio.”
@Gregory
Buying lots of lottery tickets would “diversify your portfolio”
It wouldn’t really be a winning investment strategy though would it?
Seem to recall a v good article on Aberforth here – maybe a couple of yrs back – returns have just about doubled since then. Yes, more volatile but I should think most portfolios would be rewarded with a 5% – 10% allocation over the longer term.
No free lunch! Without risk there is no premium. Relevant articly by Rick Ferri:
http://www.rickferri.com/blog/investments/to-tilt-or-not-to-tilt/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+RickFerri+%28Rick+Ferri+Blog%29
@gregory
When risk is priced expensive its a good time to run towards it, 2009, 2003 and 1993 and 1982 spring to mind
Right now risk is priced as cheap as I can think of
Like portuguese and italian government bonds yield 3% etc and Zoopa pays you a princely 4% if you’re lucky
@Neverland
I think generally not the current situation. A passive portfolio is for the long run.
I think we’re in danger of crossing the streams here guys. A passive investor doesn’t believe it’s possible/worthwhile trying to time when to buy small caps. An active investor may well think different, rightly or wrongly, and so will rail against adding a fixed allocation to the asset class and ‘blindly’ rebalancing if/when required.
As a Tuesday/Accumulator article this is clearly a passive take on small caps so suggest we leave the timing/valuation debate for another day.
Thanks!
there is also a case for going international with small cap shares. because not only do UK small caps perform differently to UK big caps; but also small caps in different countries / regions perform very differently to one another (to a greater extent than big caps in different countries, which are more closely correlated to one another, especially in recent years).
you can use something like the vanguard global small-cap index fund, which includes all developed markets (including the UK); however, it is almost 2/3 in USA/canada, which some might think is excessively concentrated in 1 region (and others would say is correct, because it’s just following the market capitalizations). it gets more complicated if you want to use different weightings for small cap in different regions.
are the suggestions that small cap looks a bit expensive now referring to the USA, UK, or elsewhere? (in the UK, i see that aberforth smaller companies has fallen back a bit over the last few months.)
oops, i take back my third paragraph … market timing on a tuesday, whatever was i thinking …
I appreciated the Aberforth article as a way to lean against the big-firm bias of my HYP. Somewhere on here I read TA even indulged as there’s no index fund equivalent to that investment trust
@ermine — Indeed, he admitted it in his investing confessions. 🙂 I think he’s written before that he can’t find a suitable small cap tracker for the UK. Glad it worked out for you.
@Gregory — Meant to say in response to your question, the portfolio you link to is our model portfolio, not T.A.’s own portfolio. I think he’s addressed the lack of small cap before, but I may be misremembering. If I recall correctly it’s simply that we want the model portfolio to be as straightforward as possible. Small caps do increase return (historically) but it’s with extra risk/volatility, plus it’s another thing to rebalance.
The model portfolio is supposed to be pretty simple, while not so simple as just a world tracker and bonds / LifeStrategy, as that would be a pretty dull portfolio for tracking and discussing show-and-tell purposes.
@The Investor
Thanks for Your answer!