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The size premium – dead or alive?

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 [1] for investors over time than their bigger brethren, albeit at greater risk.

The size premium is thus one of a quiverful of return premiums [2] that have the potential to arrow you towards your investment targets [3] – 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 [4] (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 [5] 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 small cap premium is a risk story. [6]

The risks of small caps are well known:

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 [8] 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 [9] agrees that investing in the rise of the midgets is done at your own risk [5].

It’s important to know that the size premium is strongest in the small cap value [10] sector of the investing universe.

In other words, you should look for funds that invest in small and unfavoured [11] 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 [12] 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 [13] hype.

A more sober estimate of the potential is Rick Ferri’s forecast of a 0.3% annual premium [14] 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 [15] 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