AAII Home AAII Blog

How Much Small Cap Should Be in Your Portfolio?

image_pdfimage_print

This article originally appeared in the July 2014 issue of the AAII Journal.

It may come as a surprise to those who have placed their nest eggs in an S&P 500 index fund, or an actively managed version thereof, that they are actually making a decision to exclude a significant portion of the equity universe.

Academic theory suggests market-capitalization (cap) weighting is an appropriate starting point for the weight of any asset class in the portfolio, including small caps. Market-cap weighting implies that the investor holds each asset and, therefore, each asset class in his or her portfolio in the same proportion as it is represented in the overall market. Determining market weight is an exercise in and of itself, because you must first settle on a definition of what constitutes a small or large stock. Standard & Poor’s defines the ratio of large to small stocks in the U.S. equity market as about 80%/20%. This means that if your portfolio is an S&P 500 investment, you are missing out on a good 20% of the publicly traded universe in the U.S. equity market.

A variety of considerations might motivate an investor to deviate from a 20% weight to small caps in the U.S. Home equity bias, inertia and a simple desire to minimize complication in portfolio allocation decisions are likely chief among them. It is probably worth most investors’ time to at least consider a position in small caps, if for no other reason than to diversify an existing portfolio of large caps.

An investor is well served by allocating his or her financial capital among different types of equities (i.e., diversifying), so that a bad period for one asset class can be offset by a potentially good (or, at least, less bad) period in another.

Underweight or Overweight?

If small caps are expected to outperform large caps, then some investors can increase their portfolio returns relative to the market by overweighting small caps. The expectation of outperformance of small caps relative to large caps is often dubbed the “small-cap premium.” A premium can arise for both rational economic reasons as well as behavioral considerations.

It is important to note that all investors cannot simultaneously overweight small caps since a balance in the market must be struck—the overweight of some investors must be compensated by the underweight of other investors.

In one study that looked at the performance of various types of stocks back to January of 1926, the cumulative return of small-cap stocks has been significantly greater than that of large caps.

These comparisons refer to the broad swath of small and large stocks and not to an investment in individual small or large stocks. The return of any individual stock is highly idiosyncratic and may not reflect the performance of the asset class as a whole. (It is believed that markets are generally efficient and taking on stock-specific or other idiosyncratic risk is, on average, not compensated with additional expected return.)

However, the study also showed the vagaries of small-cap outperformance. Small outperforms large just over 50% of the time. Over one 220-month period (August 1983 through March 1999) small caps underperformed large caps by 52.75% on an annualized basis. Also, small caps experienced a more severe drawdown in both duration (73 months) and magnitude (–89.40%) than large caps, suggesting greater risk for small caps.

For the purposes of an investor considering a small-cap investment, the important point is that the outperformance of small caps relative to large caps cannot be assumed over any given investment horizon.

One consideration that may prompt investors to underweight small caps is that, on a stand-alone basis, small caps historically have been riskier than large caps.

Table 1 indicates that small caps have both higher standard deviation, dispersion of returns around their mean return, and higher beta, which measures the covariance of the asset with the overall market, than large caps, although the annualized Sharpe ratio, which divides the amount of return earned over and above a risk-free proxy by the standard deviation, puts the two on par. The Sharpe ratio is a risk-adjusted measure of return and essentially measures how you are getting compensated in excess return for the risk you are taking relative to short-term Treasury bills (a larger number signifies better risk-adjusted performance).

Table 1. Risk and Return of U.S. Large Stocks, Small Stocks and the Market
Table 1. Risk and Return of U.S. Large Stocks, Small Stocks and the Market

While considering risk is essential, investors cannot stop here. As noted above, small caps do not move in perfect concert with large caps, and as a result, their higher risk is not necessarily a bad thing for the investor’s portfolio.

While holding small caps on their own may be riskier than holding large caps on their own, holding large caps and small caps together may be the least risky, because their movements are not perfectly correlated. The third row of Table 1 suggests that this is the case. The entire market has a higher Sharpe ratio than either small or large caps held in isolation.

At this point, it should be clear that most investors would be well-served by having a market value weighting in small-cap stocks. On average, this is the market portfolio of both large and small stocks held at market value weights. Individual investors, however, may find it advantageous to overweight or underweight small-cap stocks depending on their individual circumstances.

When considering interactions between your personal situation and your investments, first look at your own investment behavioral tendencies. Do you typically monitor the performance of your account on a short-term basis? Are you apt to be concerned if a particular investment underperforms in a given quarter or year? Individual investors tend not to earn the returns that markets deliver over time because they trade poorly. They tend to buy high, when an investment is doing well, and sell low, when they perhaps lose faith in the investment. If you are likely to panic and sell when small caps take a dive, you could wind up worse off than if you never invested in them in the first place.

Another important investor-specific consideration is one’s personal “human capital” and its risk. The term human capital refers to the economic value of one’s own productive capacity, specifically the present value of your lifetime labor income. Conceptually, the risk of your human capital is how the value of your human capital co-varies with the market and other sources of risk.

For example, if you are likely to experience a loss of job or reduction in your pay due to poor stock performance (e.g., because of equity-based compensation such as warrants, or bonuses based on revenue that fluctuates with stock market performance), you may want to take less stock market risk with your financial capital. This same principle is applicable when considering a small-cap investment. If you work for, or own, a small firm, you inherently have “small-cap” risk in your human capital. When small firms, in general, undergo difficulty—this may be when times are tough in general, and smaller firms are less able to weather the storm—taking additional “small-cap” risk with your financial capital may be difficult to withstand.

There are also industry effects in small-cap risk to consider: Information technology (IT) and consumer discretionary sector returns are significantly positively associated with the small-cap premium, while consumer staples and financials are significantly negatively associated with the small-cap premium. This suggests investors working in IT and consumer discretionary may consider underweighting small caps, while those in consumer staples and financials may consider overweighting small caps in their portfolios.

Growth vs. Value

As if the multitude of variables at play in the small-cap space didn’t make the decision complicated enough, investors need to be aware of another significant consideration. The group of small-cap stocks can be parsed in a variety of ways, and considering different complexions within small caps as a whole has resulted in widely different results. Perhaps the most typical dimension within which small caps can be grouped is their value or growth orientation.

Value stocks tend to have a lower stock market price relative to other measurements of the firm’s fundamentals, such as their book value of equity or earnings. Growth stocks are higher priced relative to a fundamental. Sorting small stocks by their “book-to-market” ratio, literally the ratio of book value of equity relative to the firm’s market cap, reveals startling spreads in return.

Figure 1 evidences this phenomenon using the five small-cap portfolios defined by researchers Eugene Fama and Kenneth French sorted by “book to market,” ranging from extreme value on the left to extreme growth on the right. The extreme small value portfolio has outperformed the extreme small growth portfolio by greater than 10% per year with a 10% per year lower annualized standard deviation.

Figure 1. Small Caps by Book-to-Market Ratio
Figure 1. Small Caps by Book-to-Market Ratio

Value to growth orientation is only one way to parse the greater small-cap space. Other relevant factors include stock price momentum and gross profitability. Momentum is the tendency for stocks that have performed well in the recent past to continue to do so, and vice versa. Momentum is generally measured by ranking stock performance over the course of the previous year, not including the most recent month. Stocks with performance in the top of this ranking have been found, on average, to continue to perform well for a time, while stocks at the bottom of the heap have tended to continue that underperformance. One study’s results showed that this proclivity is very evident within small-cap stocks, with higher-momentum small caps reliably (again over long periods, not in any given period), outperforming lower-momentum ones.

Another recent study found that stocks with higher profitability relative to their book value (or their total assets, depending upon the measure) tend to outperform those with lower profitability. This finding also applies to small caps. There are now a myriad of mutual funds and exchange-traded funds (ETFs) in the U.S. small-cap space that use these insights in building small-cap portfolios engineered to capture momentum, profitability/quality and value premiums.

Conclusion

A market-weight allocation to small-cap stocks is generally a reasonable starting point for those considering a small-cap investment.

However, small-cap stocks have tended to be riskier than large caps, and the small-cap premium is highly volatile and, therefore, may not be positive even over long periods of time. For both of these reasons, investors prone to frequently examining their performance may not be suited to a portfolio with an overweight to small caps.

Additionally, the investor’s human capital should be considered. At its simplest, investors who work for large companies may be better suited to a higher small-cap investment than those who work for or own small companies. Finally, small-cap growth stocks, particularly the most extreme growth stocks, have significantly underperformed small-cap value stocks. If you excise this group of small-cap stocks, the small-cap premium is very evident. A lack of profitability may be to blame for the underperformance of these stocks. Human capital considerations again come into play, if the investor works for or owns either a “startup” type of small firm or a small “distressed” firm.

In sum, most investors would probably be well-advised to have an allocation to small caps. Further, if the investor is not sensitive to small-cap risk in their human capital, an overweight to small, and especially small value, stocks presents an opportunity to improve portfolio performance. While we focus on investing in U.S. small-cap stocks, our conclusions apply as well to small-cap investing outside the U.S., as is supported by research from Fama and French.

John McDermott, Ph.D. is an associate professor of finance at Fairfield University’s Dolan School of Business and chief investment strategist at the investment management firm Symmetry Partners LLC in Glastonbury, Connecticut. Dana D’Auria, CFA is the director of research at Symmetry Partners LLC in Glastonbury, Connecticut.

If you are not an AAII member and want to gain access to all the benefits of membership, simply take a risk-free 30-day Trial AAII Membership and start becoming an effective manager of your own assets.

 

Leave a Reply

Your email address will not be published. Required fields are marked *