Practical analysis for investment professionals
10 June 2019

The Case Against Small Caps

Small vs. Large Stocks

In the David vs. Goliath scenario, a smaller, weaker character faces down and defeats a larger and stronger opponent. Such triumphant underdog storylines abound in the realm of business: Think Netflix vs. Blockbuster, Alibaba vs. eBay in China, or Amazon vs. Barnes & Noble.

For small companies, survival is much more of a struggle than for their larger, more established counterparts. Their greater challenge is reflected in higher business risk. In the US stock market, the smallest 10% of companies by market capitalization exhibited annualized volatility of 15.3%, compared with 14.1% for the largest 10%, according to data going back to 1926 from the Kenneth R. French Data Library.

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Investors naturally expect to be compensated for holding riskier stocks. But the Size factor, which represents a strategy of buying small-cap stocks and shorting large caps, has not generated attractive returns over the last 90-plus years. But maybe market capitalization is the wrong metric. Could different measurements of size have generated better performance?

The Long View

Returns from the Size factor have been almost flat since 1926, with some significant boom-and-bust cycles. The first influential paper on excess Size factor returns was published by Rolf W. Banz in 1981 — the approximate performance peak for the Size factor.

Although the returns were positive across the entire observation period, they were not especially robust given decade-long drawdowns. Making matters worse, the data excludes transaction costs and thus overstates returns.

The Long-Short Size Factor in the US Stock Market

Source: Kenneth R. French Data Library

Measuring Size Differently in the US Stock Market

Market capitalization is the prevailing metric for weighting stocks in equity indices. But it is not the only way to measure the size of companies. We used four alternatives and applied them in the US stock market. The results showed varied Size factor performance since 2000.

Market capitalization and average daily value traded (ADV) yielded almost identical returns. This is intuitive since the stocks with the largest market capitalizations tend to be among the most traded. Enterprise value, which comprises market capitalization and debt, resulted in flat performance. In contrast, weighting companies by total assets and total sales generated negative returns.

The strong performance of market capitalization and ADV between 2000 and 2002 is best ignored since it resulted from the rebound following the severe tech bubble drawdown as investors preferred large over small companies.

The US Long-Short Size Factor: Alternative Metrics

Source: FactorResearch

To analyze the alternative Size metrics, we looked at the current median market capitalizations for the long and short portfolios. We found the portfolio characteristics are comparable across the different metrics, except for total assets and total sales, which feature smaller companies in the long portfolio as measured by market capitalization. This likely reflects a preference among investors for fast-growing, asset-light companies over more mature businesses with greater assets and sales.

Median Market Capitalization ($ billions) for Alternative Size Metrics

Source: FactorResearch

Next, we developed a sector breakdown of the long portfolio of small caps for the different metrics from 2000 to 2018. This yielded the following observations:

  • Market capitalization was the most diversified across sectors.
  • Enterprise value was dominated by the technology sector — likely a reflection of tech stocks’ comparatively low leverage.
  • ADV: Financials contributed most stocks, although it’s difficult to explain why.
  • Total assets was heavy with tech and health care stocks, probably because such companies have few assets.
  • Total sales: As with total assets, technology and health care (biotech) stocks tend to grow quickly, but often have little or no sales.

Overall, from a sector perspective, alternative Size factor metrics resulted in diverse portfolios.

Sector Breakdown for Alternative Size Metrics: Long Portfolio, 2000–2018

Source: FactorResearch

Europe to the Rescue?

The lack of a US small-cap premium is perplexing. But maybe the US equity market is an outlier. The same strategies applied in European stock markets, it turns out, yield positive and relatively consistent returns since 2000. The alternative metrics show somewhat similar trends, in contrast to the conflicting US results. So maybe there’s hope for small-cap investors after all.

The European Long-Short Size Factor: Alternative Metrics

Source: FactorResearch

Small vs. Large Stocks in Asia-Pacific

But what about elsewhere? Could the Japanese stock market offer a similar small-cap premium? Apparently not, no matter what small-cap measure is used. As in Europe, the alternative Size metrics show comparable trends. But the performance is disappointing.

The Japanese Long-Short Size Factor: Alternative Metrics

Source: FactorResearch

Comparing the Size Factor by Regions

Finally, we created equal-weight portfolios of the various small-cap metrics, including market capitalization, and compared Size factor performance across regions.

Investors were rewarded for buying smaller, riskier companies in Europe, but not in the United States or Japan. This would seem to cast doubt on the very existence of the small-cap premium.

Common equity factors like Value or Momentum tend to exhibit similar trends across different stock markets and even asset classes. But Size factor performance is relatively heterogeneous, except in Europe and Japan, from 2006 onwards. An interesting question to explore is why investors buy cheap or winning stocks at approximately the same time, but not necessarily small stocks.

Long-Short Size Factor Combinations across Regions

Source: FactorResearch

Further Thoughts

Investors frequently combine factors and including the Size factor in a multi-factor portfolio boosts performance, according to research. Sorting for small and cheap stocks, for example, is a popular strategy.

But billions have been allocated to pure small-cap mutual funds and exchange-traded funds (ETFs) on the basis of the small-cap premium. And long-term data for the US stock market contradicts this strategy’s underlying thesis — that the greater risk yields greater returns. Results across regions since 2000 provide a mixed verdict.

Unfortunately for aspiring small-cap investors, the message is clear: Alternative Size factor metrics do not boost performance. So while most of us may enjoy rooting for the Davids, we’re probably better off betting on the Goliaths.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ZU_09

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About the Author(s)
Nicolas Rabener

Nicolas Rabener is the managing director of Finominal, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real estate across asset classes. He started his career working for Citigroup in investment banking in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

11 thoughts on “The Case Against Small Caps”

  1. Michael says:

    When you compare the Russell 2000 to the S&P 500 for the past twenty years you get a 7.4% vs 5.63%. Not sue why your article didn’t include this basic info? Maybe I’m missing your point?

  2. Rabener says:

    Hi Michael, thanks for your question. The data presented also shows that over the last 20 years small caps outperformed large caps. However, there is no consistency in that performance and it is highly dependent on the starting point, e.g. if you start in 2000 you’re capturing the rebound from the Tech bubble, where large caps outperformed small caps. If you look at the 90-year data from Fama-French (first chart), then you can spot decade-long underperformance from small caps, e.g. 1980 – 2000. The research was aimed to investigate if alternative metrics to market cap would provide more consistency, but the results do not indicate that.

  3. Kirk Cornwell says:

    Interview a small-cap with the same questions you would ask a prospective employer (i.e. Where do you want to be in five years?).

  4. mike says:

    If investing in small caps purely based on indexes wouldn’t that understate what the performance would be of holding the underlying individual small cap securities (based on a selected starting point) since inherently any outperforming small cap would be reconstituted once it reaches a certain cap size (limiting the index to hold only underperforming small cap securities)?

    1. Hi Mike, thanks for your thoughtful question. We partially avoid the issue of having too many underperforming small caps by imposing a minimum market cap of $1bn, i.e. the index excludes companies that heading into bankruptcy.

      I also just ran the index with monthly and semi-annual rebalancing, which highlights slightly better CAGRs for the latter, supporting your argument. However, the performance is almost identical in trend and has not been particularly attractive since 2004, i.e. post the rebound from the Tech bubble.

  5. David says:

    Does leverage have any to do with this? If we take a look at the growth rate of earnings of mid/small caps vs large caps we will probably find that small and mid caps tend to have greater growth rates and therefore you would expect greater growth rates from them. Still we don’t see that and maybe it is because larger companies have access to cheaper and bigger access to debt, which then in turn would enhance their equity return, and I think that is someting that exacerbated after the last financial crisis and the subsequent overregulations in the bank’s balance sheets that made debt more restrictive to small and mid cap companies.

    1. Hi David, I had a look at the median market caps of the Growth and Leverage factors since 2000. There was not a significant difference in market caps between fast and slow growing companies, i.e. small companies weren’t growing faster than large caps. However, large companies were indeed more levered, which would support the argument for higher returns on equity for lare caps.

      Somewhat conflicting is that higher leverage should reflect in larger drawdowns during market downturns, but large caps outperformed small caps during the GFC, which poses new questions.

  6. Leonard Rosenthal, Ph.D. says:

    Isn’t the argument against using market caps which are less than $1bn being partly driven by the need for having stocks with market caps that most institution can buy? Forget about the bankruptcy question as everyone agrees that small caps are risky and the smaller the cap, the more the risk. What would happen is you look at companies in the the $500mn to 1bn range and the $250 to $500 mn range? This is the only fair way to look at the small cap effect? Then if the lowest market cap does well, you can raise questions of liquidity, etc.

  7. Nicolas says:

    Hi Leonard, yes, most institutional investors are constrained from investing in small caps from a liquidity perspective.

    We looked at small and microcaps in another research note, which highlights that investors haven’t been compensated for higher risks. Here is the link:

  8. Pete says:


    If I buy stock in a small cap and it performs exceptionally, to the point that it’s market cap now is in midcap territory such as Graco (GGG), isn’t it a case of the small cap index’s loss is the mid caps gain?

    Could it be the superior small caps perform so well that the index suffers when their capitalization is too large and they become mid and large cap stocks?

    Large cap performers rarely see their capitalization fall below their large cap status and if they do, they get acquired.

    The same can be said of small caps. Once their growth appears on everyone’s radar, large caps acquire some of them.

    What this says is good research is likely to beat indexing when it comes to small caps

  9. Austin says:

    This is interesting stuff, but, if the market cap weighted version of the size factor does outperform, and a small cap investor is in fact investing their assets based on market cap, not on the alternative measures provided, then the entire argument of using different metrics does not apply to said investor.

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