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The Small Firm Effect – The Outsized Performance Factor in Smart Beta ETFs

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Posted on: 31.08.2017

Over the long term, small capitalization stocks have produced higher returns than large cap stocks but in exchange for more volatility. After two decades of small cap stocks outperforming large caps in the 1970s and 1980s, investors wanted to know what, if any, premium they were being paid for the bumpy ride.

So when an American-Swiss finance professor Rolf Banz analyzed the size effect of small cap stocks in 1982, among the paper’s enthralled  reviewers were three future Nobel laureates in economics.[1] The discovery of the “small cap risk premium” –  over a 40-year period to 1975 small cap stocks outperformed large cap stocks on a risk-adjusted returns basis – officially made size an investment factor.

The size factor is commonly applied to equities. Size is determined by market capitalization – shares outstanding multiplied by price per share. The three major fund classifications by size are:

Large capitalization – Greater than $10 billion

Large capitalization stocks are associated with a conservative risk-return profile.

Medium capitalization – $2–$10 billion

Investors often look to mid-cap growth stocks for extra return. Mid-caps offer higher growth than large caps but without the volatility of small caps.

Small capitalization – Less than $2 billion

Small capitalization stocks typically have above average but more volatile sales and earnings growth. As a result, they have a higher risk rating. A conservative small cap investment strategy is growth at a reasonable price (GARP), whereby the fund targets higher growth companies but also screens for value criteria.

Equal Weighting

One of the most popular alternative weighting strategies commonly being labeled as ‘smart beta’ is equal weighting.  Equal weighting is showing the ability to outperform market beta with the 10-year cumulative return for the S&P 500 Equal Weight index is 130% versus 106% for the S&P 500 index.[2]  While there isn’t much smart about simply equal weighting a selection of stocks, a fundamental analysis of this approach shows exposure to the size premium.  Think about it logical, market cap weighted indexes are generally dominated by the few largest holdings as is the case with the S&P 500 where the top 10% of largest companies account for close to close to 50% of the index (link to an article I wrote with more on this subject).

Since different risks are associated with the three market capitalization levels, diversifying by size allows investors to better align their risk profile with a suitable exchange traded fund. Following the  development of the first and leading small cap benchmark, the Russell 2000, in 1984, the small cap asset class has been widely adopted as part of diversified investment portfolios.

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Equal Weight Smart Beta ETF Investing | Guggenheim Investments

Equal weight investing is a smart beta strategy that does exactly what its name implies-it equally weights every stock in the strategy regardless of how small or large it is.

Returns

Small cap stocks have continued to outperform over the long term. Over 17 years from March 2001, small-cap stocks returned almost 300% more than large-cap stocks based on the MSCI Global Small Cap Index and MSCI Global Large Cap Index, respectively.

In 1992, the Fama-French three factor model (market risk, size and value) found that both the size (small vs large cap) and book-to-market equity (value vs growth) factors deliver a higher risk-adjusted return in NYSE stocks, and thus the model adjusts for the outperformance of size and value when valuing a stock. The risk-adjusted return measures a stock’s performance relative to its beta (β) – a measure of the volatility of a security relative to the market as a whole.

In a later study in which they extended the time horizon across a value-weighted market portfolio of the major US stock exchanges, both the small cap size and value premium persisted. Focusing in on the size premium, the average small cap size premium was .23 percent from 1926-2004.

In the smart beta ETF universe, the Credit Suisse Global Investment Returns Yearbook shows small size factor smart beta ETFs outperforming their large cap counterparts by .45 per month since 2000, but narrowing the pre-2000 performance gap.

Smart Beta ETF Returns by Size

The following chart shows small cap smart beta ETFs doing well in the current bull market. In periods of sustained rising stock prices, small-cap stocks tend to outperform large-cap stocks; over a longer term, the performance gap persists but narrows. The comparable five your returns may be explained by the lower volatility since 2013. While small cap stocks have a higher beta and returns on average, the asset classes actually perform a cyclical dance in which they periodically exchange risk and stock performance leadership.

 

 

Smart Beta ETF 1-year Return 5-year Return 5-year Return Benchmark Beta
iShares Russell 3000

 

17.87 12.99 13.18 1.07
iShares Russell Midcap ETF 16.79 12.90 13.09 1.22
iShares Russell 2000 ETF 29.25 12.44 12.54 1.58

 

 

Corey Philip

Corey Philip is the founder of RealSmartBeta.com. His focus is on expanding investor knowledge of Smart Beta ETFs and quantitative investing. Learn more about Corey in the 'ABOUT' section of this website.

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