Continuing with our series on style premiums, today I will talk about the size premium or the tendency for small cap stocks to outperform large cap stocks.
What is it?
In the US the small premium is defined as the return of the smallest 50% of stocks by market cap minus the return of the largest 50% of stocks by market cap. It is commonly referred to as SmL (Small minus Large). The small premium has been found to exist in all markets including developed and emerging international markets. It was first “discovered” in 1981 by Rolf Banz. Like all true style premiums, since its discovery it has persisted in a way consistent with the original findings.
In the US we have data going back to 1927. From 1927-2012 the small premium was 3.08% per year with a standard deviation (a measure of volatility) of 12.82% per year. The small premium is smaller and relatively more volatile than the equity premium with the yearly return over 4 times its yearly volatility (verses about 2.5 times for the equity premium). This means that there can be long periods where large caps outperform small caps.
In the US the small premium has had a correlation to the equity premium of 0.38. Anything less than 1 indicates that tilting your portfolio towards small cap stocks adds some diversification benefit. However, the small premium tends to be negative during years where the equity premium is also negative.
Why It Exists
Academia has pretty much agreed that the small premium exists for the compensation of taking additional risk. The exact reason small companies are riskier than large companies is still debatable. Some of the most compelling arguments are:
• Small companies are more tied to their local economy and are unable to tap into other markets
• Small companies have a harder time gaining access to credit in poor markets
• The bankruptcy rate is higher in small cap stocks
• The stocks of small company are bought and sold in less liquid markets, so there is some liquidity premium for owning them.
How To Capture It
Owning an ETF or mutual fund that tracks the Russell 2000 or similar index will give you access to the small premium. This will give you exposure to about 60%-80% of the small premium. Since it is defined as only the smallest 50% of stocks minus the largest 50% it is possible for a micro cap fund to gain over 100% of the small premium.
Since the Russell 2000 is a diversified portfolio of stocks it will usually give you access to the equity premium PLUS some percentage of the small premium. This allows for larger (or smaller) returns than the market, depending on the performance of small cap stocks.