Maximizing the benefits of owning small caps depends in part on how you piece the puzzle together.
A version of this article appeared in the August 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
Depending on which index provider's definition you rely on, small caps make up anywhere from 3% to 13% of the total investable market capitalization of the U.S. stock market. Looking outside U.S. borders, small caps account for 16% 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.
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.
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 the 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.