A new study by Frontier Asset Management is calling into question the long-held belief that US small capitalisation equities routinely outperform their large cap peers. In fact, on a risk-adjusted basis, the study shows the opposite to be true over much of the past 75 years.
“We were originally looking at what had happened to the purported advantage of small cap over large cap that was based on research from the 1980s,” says Scott MacKillop, president and chief compliance officer of the Denver-based investment house.
“We went and looked at the period from 1982 until the present, and we looked at risk-adjusted returns and found that large cap beat small cap by a small margin, which is kind of what you’d expect after the research – people would invest in that anomaly for that period.
“Then we looked from 1926 to the present, and large cap was ahead of small cap, as well. The margin was a little bit bigger than what we had expected. We couldn’t find any period where small cap had the risk-adjusted advantage.”
Frontier compared the risk-adjusted monthly returns of the CRSP 9-10 Index (which includes the smallest fifth of New York-listed stocks and their equivalents from other US exchanges, sometimes referred to as micro-cap stocks) and the S&P 500 Index to reach its conclusion. During each period studied, large caps marginally outperformed small caps when using the Sharpe ratio, which evaluates the risk-to-reward ratio of an investment.
Mr MacKillop says his company’s findings have implications for managers who might be overweight in the “wrong” strategies due to adherence to prevailing theories on US equities, some based on the oft-cited Fama and French “three factor model” research.
“I think really the implication is, rather than overweighting small cap stocks, you might have equal weighting or [be] overweight large cap stocks, which I think over time could help the risk-adjusted performance of an institutional portfolio significantly,” he says.
One consultant says that, over time, his firm still believes small cap equity will outperform, but adds that, when it comes to risk, large caps could have a short-term advantage.
“We have long-term forecasts, with 10 or 30-year time horizons,” says Mike Sebastian, principal at Hewitt Ennis-Knupp. “Over that time, we think passive US small cap will outperform modestly. Considering volatility, which is going to be high, especially with small cap stocks, on a risk-adjusted basis, we expect small caps to produce a return moderately short of large caps [in the short term].
“Over the medium term, we think small caps have a bit of a headwind because of valuations and the weak economic data that we’ve seen recently. We think that will be an additional drag on small cap performance in the interim.”
Another consultant says she believes there is a premium on small caps, given their ability to outperform in the long run.
“Smaller companies should have better ability to grow faster than large ones,” says Hilary Wiek, director of investment research at Rogerscasey. “It should be easier for a small company to double in size than a very large company. Stock prices should eventually reward better growth rates.”
Ms Wiek also says that small cap companies are more likely to be the subject of merger and acquisition activity. “M&A tends to result in companies being bought at higher prices than they had traded at prior to an announcement,” she adds.
“A naïve portfolio of small cap names should be able to benefit from this phenomenon.”
Still, Mr MacKillop’s company’s research suggests that, despite all of the qualities that make small caps ripe for outperformance, large caps remain the steady winner over time.
“It’s always good to go back and question the established beliefs in investing,” he says.
Mariah Summers is a reporter on FundFire, a Financial Times publication, where this article first appeared
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