As the director of research for The BAM Alliance—a community of about 140 like-minded RIA firms who believe in providing a fiduciary standard of care using an evidence-based investment strategy—I often get requests from other advisors for my help in answering questions from clients about articles they’ve read in the financial media.
As such, I thought I’d share my thoughts on a January article from Pension Partners LLC, an investment advisor and manager of the ATAC Rotation mutual funds, titled: “Do Small Caps Really Outperform Over Time?”
The article makes the case that while small-caps have outperformed over the full history for which we have data (beginning in 1926), they have underperformed since 1979. The article supports this contention by comparing the return of the Russell 2000 Index (R2K) to that of the S&P 500 Index over the 37-year period from 1979 (when the R2K was introduced) through the end of 2015.
During this period, the article states, the R2K underperformed the S&P 500 by 1.4 percentage points (11.7% versus 10.3%). I went and checked the data, and while the R2K did underperform, it actually returned 11.4%, not 10.3%. Thus, its underperformance was just 0.3 percentage points.
It’s interesting to note Pension Partners’ use of the R2K to represent small-cap funds, because it’s well-known that there are problems with that index—problems that have allowed active managers to front-run the indexers. This led to poor returns on the index, and eventually most index funds (such as Vanguard’s small-cap fund) abandoned the use of that benchmark.
A Better Small-Cap Benchmark
A superior small-cap index is the CRSP (Center for Research in Securities Prices at the University of Chicago) 6-10 Index. For the period January 1979 through November 2015, the CRSP 6-10 returned 13.0%, outperforming the S&P 500 Index’s return of 11.8% by 1.2 percentage points per annum.
During the same period, the R2K returned 11.6%, underperforming the very similar CRSP 6-10 Index by 1.4 percentage points. Thus, simply by using a more appropriate index, the underperformance of small-caps disappeared and they outperformed.
I would also note that the 1.2 percentage point outperformance of the CRSP 6-10 Index for the period January 1979 through November 2015 isn’t that far off from the performance differential in the period prior to 1979. From 1926 through 1978, the CRSP 6-10 Index returned 10.5% per year, outperforming the S&P 500 Index’s return of 8.9% per year by 1.6 percentage points per year.
I’d add that the lesser small-cap premium shouldn’t really come as a surprise. Small-caps are more expensive to trade, especially in tough times. Thus, investors should demand a liquidity premium for that risk. And liquidity costs have dropped sharply as bid/offer spreads have fallen since the advent of decimalization and with the impact of high-frequency traders.
Further, thanks to financial innovation, investors can now access less-liquid, small-cap equities indirectly through low-cost index funds and ETFs. These regime changes also help explain why the equity risk premium is now lower as well. However, we should not be surprised that there has been a small-cap premium. And we should continue to expect one in the future.
Explaining The Small-Cap Premium
What makes small-caps riskier than large-caps? Another way of asking this question is: What is the source of the small-cap premium? There are numerous intuitively logical explanations, all of which are well-known. Relative to large companies, small companies typically are characterized by:
- Greater leverage.
- A smaller capital base, reducing their ability to deal with economic adversity.
- Fewer and more expensive alternatives in terms of access to capital. Their lower levels of collateral leave them more susceptible to tight credit conditions that exist during recessions.
- Greater volatility of earnings.
- Lower levels of profitability.
Other explanations might include: