Swedroe: The Small Cap Growth Anomaly

Small-cap growth stocks are the ‘black hole’ of investing.

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Reviewed by: Larry Swedroe
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Edited by: Larry Swedroe

Today I’ll continue my look at an important question facing investors: Do small-cap stocks really outperform over time?

Earlier this week, I demonstrated that, despite claims by investment advisor and mutual fund manager Pension Partners that small-caps had underperformed since 1979, when looked at in the proper light, small-caps actually have outperformed. The article also provided the logical, risk-based explanations for small-cap stock outperformance found in the academic literature.

Let’s extend the discussion by looking at the returns of small-cap stocks through a multifactor—instead of single-factor—lens. By doing so, we can see that the evidence supporting small-cap outperformance becomes much stronger if one considers more than just the single factor of size.

A Multifactor Approach

The issue of the size premium is complicated by the well-known anomaly that, while small value stocks have provided higher returns than large value stocks, small growth stocks have provided lower returns than large growth stocks. Using the Fama-French indexes, the table below provides the annualized returns and annual standard deviations of these asset classes for the period July 1926 through November 2015:


Asset ClassAnnualized
Return (%)
Annualized Standard
Deviation (%)
Small Value13.829.2
Large Value11.024.8
Large Growth9.618.6
Small Growth9.127.9

While they produced lower annualized returns than large growth stocks, small growth stocks exhibited higher volatility. From a traditional finance (risk-based) viewpoint, the returns and volatility of large growth, large value and small value stocks line up as they should (higher returns are positively correlated with higher volatility). However, the return and volatility of small growth stocks don’t line up as expected. Thus, they present an anomaly.

The article from Pension Partners looked at the data beginning in 1979, so I’ll do the same. The table below presents the data from January 1979 through November 2015:


Asset ClassAnnualized
Return (%)
Annualized Standard
Deviation (%)
Small Value15.020.2
Large Value12.015.9
Large Growth11.616.2
Small Growth9.123.7

Here, too, we find that small value stocks had the highest returns, and small growth stocks produced the lowest returns, and did so with the highest level of volatility.

We’ll take one further look at the data. This time we’ll analyze the period January 1993 through November 2015—a period we can call “post Fama-French” (their famous research paper, “The Cross-Section of Expected Stocks Returns,” was published in 1992). Doing so will allow us to view the results post-publication of their work:

Asset ClassAnnualized
Return (%)
Annualized Standard
Deviation (%)
Small Value12.521.9
Large Value8.716.8
Large Growth9.015.0
Small Growth7.523.4

Once again, we find that small value stocks had the highest returns and small growth produced lowest returns, and did so with the highest level of volatility. It’s easy to see why small growth stocks have been referred to as the “black hole” of investing. But before looking to see if we can explain the poor performance of small-cap growth stocks, we will evaluate the data from international markets to determine if it’s consistent with the evidence from the U.S.

DFA Digs Into The Problem

Thanks to the research team at Dimensional Fund Advisors (DFA), we find that the “black hole” exists in 23 developed international markets as well. To establish this, DFA researchers divided the market into quintiles, ranking stocks both by market capitalization (size) and book-to-market ratio (value). (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

For the period November 1990 through March 2011, the most extreme small growth stocks (or smallest, most growth-oriented quintile) were the poorest-performing, and returned just 0.8 percentage points above the rate on one-month U.S. Treasury bills. They underperformed the largest, most growth-oriented quintile by 2.8 percentage points per year and the smallest, most value-oriented quintile by an astounding 12.6 percentage points a year.

The evidence strongly suggests that investment strategies that include extreme small-cap growth stocks have lower expected returns than strategies that exclude them. On the other hand, strategies that exclude small growth stocks sacrifice some diversification. Investors are faced with the following trade-off: increased diversification versus higher expected returns.

DFA’s research shows that, by systematically identifying and excluding only the extreme small-cap growth stocks from small-cap and marketwide strategies, investors could improve the expected returns on those strategies while maintaining broad diversification among the small-cap universe.

Avoiding The Black Hole

DFA sorted U.S. stocks independently on the book-to-market (BtM) ratio scale, the earnings-to-price (E/P) ratio scale and the cash flow-to-price (C/P) ratio scale, and then defined extreme small-cap growth stocks as small-cap stocks in the bottom 25% of the small-cap market measured by BtM, as well as in the bottom 25% of the small-cap market by either E/P or C/P.

For the period 1975 through 2011, small-caps stocks returned 16.7% annually. The most extreme small-cap growth stocks returned just 8.5% annually. Excluding extreme small-cap growth stocks, which represent only 12% of the small-cap universe, the return to small-cap stocks would have been 17.6%. Thus excluding them, while sacrificing little in the way of diversification (it would maintain exposure to 88% of the small-cap market), would have increased returns by 0.9 percentage points.

The evidence was similar in international markets. For the period 1995 through 2011, small-caps returned 7.2%. But the most extreme small-cap growth stocks (about 12% of the overall international small-cap market) returned just 1.1%. Excluding these stocks would have raised the return of small-caps to 8.1%. What’s more, the results were similar in every country—the most extreme small-cap growth stocks managed to produce the worst returns.

The bottom line is that the research shows it’s easy to see that we can improve on the returns of a small-cap strategy by either limiting small-cap exposure only to small value stocks, or using the research to screen out the stocks within the small-cap universe that exhibit the worst performance. Fortunately, there’s a large body of evidence that allows us to accomplish this objective.

Later this week, we’ll present some additional findings from the research on small-caps, including from the field of behavioral finance.


Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.