The Small-Cap Effect Strategy

The Small-Cap Effect Strategy – Performance, Investing, Factor, Returns Analysis

Today we will introduce you to a well-known stock market anomaly – the small-cap effect strategy.

Small-cap stocks are one of the types/factors you can invest in and hold in your securities portfolio.

Small-cap stocks differ from large- and mid-cap stocks in several ways and have advantages and disadvantages.

If you want to invest in small-cap stocks, this article is for you. We explain the small-cap effect, what it is, and we backtest different classes of small-cap stocks and compare the results with mid- and large-cap stocks. We will see if small-cap stocks outperform mid- and large-cap stocks.

What is a small cap stock?

Related reading: Looking for an investment strategy? (We have hundreds)

In the US market, we define the different market capitalizations like this:

  • Small-cap stocks are stocks with a market capitalization between $300 million and $2 billion;
  • Mid-cap stocks have market caps ranging from $2 billion to $10 billion;
  • Large-cap stocks break the $10 billion mark.

Market capitalization refers to the total value of a company’s shares traded on a stock exchange. It is calculated by multiplying the total number of issued shares by the market price of one share.

Many investors mistakenly believe that small-cap companies are start-ups or brand-new companies. In fact, many small-cap companies are well-established businesses with solid track records and excellent financial performance. That said, the small-cap sector is a mixed bag, as you’ll learn from this article.

What is the small-cap effect?

The small-cap effect refers to a phenomenon observed in the financial markets, particularly in the stock market, where smaller companies tend to outperform larger companies over time. It suggests that investing in stocks of smaller companies can lead to higher returns compared to investing in stocks of larger, more established companies.

In a way, it makes sense because smaller companies might have a longer runway than larger ones. The small-cap effect is based on the theory that smaller companies have greater growth potential and are more likely to be undervalued by the market. Smaller companies often can grow faster because they operate in niche markets, have innovative business models, or can quickly adapt to changing market conditions. As these companies grow and gain recognition, their stock prices may increase, resulting in higher returns for investors.

There are several reasons proposed to explain the small-cap effect. One reason is that analysts and institutional investors less widely follow smaller companies than larger ones. This lack of attention can lead to less efficient pricing, creating opportunities for investors to find undervalued stocks. Additionally, smaller companies may be more flexible and agile in responding to market opportunities, making them more likely to experience rapid growth. Many argue that small-cap factor investing is mostly due to the value effect (small companies are valued less than larger).

Investing in smaller companies also carries higher risks than larger, more established ones. Many small caps have unproven business models and are likelier to go belly-up. We believe the returns are skewed to a few multi-baggers, while the great majority go nowhere (or south).

Smaller companies may have limited financial resources, higher volatility, and less liquidity, which can increase the potential for losses. Therefore, investors should carefully assess the risks and make sure they are diversified well.

Is there an international small-cap effect?

Yes, it’s not only in the US we see this effect.

For example, one of the best small-cap markets has been in the Nordics (Norway, Sweden, Denmark, and Finland). This region has a vibrant small-cap culture, especially Sweden. We have covered this in our article about 7 reasons to invest in Nordic stocks.

Small-cap stocks and volatility

How has the small-cap sector fared since JFK was president?

The table below shows that you both find the worst and the best stocks in the small-cap sector. Let’s look at the relationship between market value and volatility for US stocks from 1963 to 2018 (research done by “Plutous” on SeekingAlpha):


Lowest volatilitySecond lowestMedian volatilitySecond highestHighest volatility
Lowest market cap16.73%17.54%15.58%10.48%-2.76%
Second lowest15.20%16.1%15.64%12.99%3.43%
Median market cap13.43%13.71%14.84%13.18%5.76%
Second highest12.69%13.0%12.96%12.02%6.9%
Highest market cap9.72%10.87%10.15%8.95%7.81%

The worst stocks have been volatile small caps (not made any money since JFK was president!), and the best stocks have been the least volatile small caps. As you can see from rows 1-3, the bigger the companies, the smaller the returns. This is the small-cap effect! The only exception is the most volatile stocks. We know from a previous article that the low volatility strategy factor is one factor that has been relatively consistent in the stock market.

Small caps vs. large caps long-term historical chart

Nick Maggiulli has written an article called Is Small Cap Investing Right for You? where he summarized the small – and large-cap returns by decade:

Small cap annualized stock returns

The table above shows that small-caps outperformed large-caps every decade except the 1950s until 1979 but underperformed every decade since then, except for the 2000s.

During the last three decades, small-cap stocks have underperformed compared to large caps. The chart below shows that the Russell 2000 index has underperformed compared to S&P 500 since 1988. The chart doesn’t include reinvested dividends, and hence the difference is probably even bigger:

Small-cap effect strategy

However, if we look at global small caps, the results differ:

Global small cap performance

The chart is from a white paper called Why Invest in Global Small-Cap Equities? by Nicola Wealth.

The conclusion from history is that you need to be diversified. You don’t know which asset classes will perform the best, so you better ensure you have some broad and diversified allocations.

Do small caps or large caps perform better in recessions?

Because most investors tend to fold and sell in a downturn when inevitable losses set in due to our investing biases, it might be interesting to know which group performs the best when markets head south.

Research by Schroders, the investment bank, shows the following:

Small-capsLarge-caps
Recession and recovery9.94.9
Expansion and slowdown5.58.5

The fear of an economic recession probably has a disproportionately negative impact on the value of smaller companies. This can be explained by their greater sensitivity to economic conditions and lower liquidity compared to larger companies.

Large-cap companies, being generally of higher quality, have more control over their future outcomes. Their size enables greater revenue diversification, reduced operating risks, and stronger supply chain influence.

Furthermore, during periods of heightened uncertainty, investors tend to seek security, prioritizing short-term safety over long-term returns. As a result, capital is often redirected towards areas with greater liquidity.

Armed with this understanding, the market tends to sell off small-cap companies as a recession looms, favoring more liquid large-cap stocks.

However, this selling can become excessive. It is akin to a herd of animals swiftly changing direction to avoid danger, illustrating the rush of capital away from small caps in anticipation of a recession.

Thus, contrary to what might feel right, it’s best to buy small-caps when times look bleak.

Is it better to invest in large caps or small caps?

Based on the long-term evidence from the table above, we see that small caps have been superior. However, that is over long periods. It might be different during shorter periods, as the backtest we do shows.

Thus, you want to have a diversified portfolio. Diversification is the only holy grail in trading and investing!

Advantages (pros) of Small-Cap Stocks

  • Less Popular: Because small cap companies are less publicized, they are not as well known as large- and mid-cap companies. This means that they are often valued below their intrinsic value and can provide a high return on investment;
  • Potential for Growth: Since these companies are smaller, they have more potential for growth compared to large-cap companies;
  • Business Diversity: Small-cap companies are not just startups. They can be found in all industries and many of them have been in operation for some time. This provides many investment opportunities.

Disadvantages (cons) of Small-Cap Stocks

  • High volatility: Smaller companies react more strongly to market volatility because they have less financial cushion than larger companies;
  • Low liquidity: The smaller size and lower popularity of small cap companies make their shares less liquid. You might move the price if you buy or sell;
  • High Risk: Even though small-cap companies have great growth potential, they have a similar potential to go bankrupt. Such companies usually have less access to investment capital and are more sensitive to market changes.
  • Less analytical info: Financial institutions and analysts do not pay as much attention to small-cap companies as they do to large- and mid-cap companies.

The Small-Cap Stock Portfolio

Let’s build a portfolio that will include different classes of small cap stocks. We will not select individual stocks, but rather ETFs, which are diversified “pools” of small-cap stocks:

Asset CategoryETF NameETF TickerWeight
Small-Cap BlendiShares Russell 2000 ETFIWM25%
Small Cap ValueVanguard Small Cap Value Index FundVBR25%
Small Cap GrowthiShares Russell 2000 Growth ETFIWO25%
Small-Cap International BlendiShares MSCI EAFE Small-Cap ETFSCZ25%

Backtesting The Small-Cap Effect Stock Strategy Portfolio

Let’s backtest the Small-Cap Stock Portfolio under the following conditions:

  • A simple “Buy & hold” strategy is used;
  • Annual rebalancing takes place on January 1 of each year;
  • Described ETFs with the appropriate weights are picked;
  • Historical quotes are adjusted for dividends and fixed-interest payments;
  • The backtesting interval from 2004 until today.

Portfolio equity curve of the backtest:

Small cap strategy backtest

The portfolio’s underwater curve (drawdowns, i.e., decline in value from a relative peak value to a relative trough):

Small cap factor investing performance

Portfolio monthly and annual returns:

YearJanFebMarAprMayJunJulAugSepOctNovDecYr%
20041.8%1.0%0.8%-4.2%1.6%3.1%-4.9%-0.6%3.5%1.5%6.6%2.2%12.7%
2005-3.1%1.3%-2.2%-4.1%5.1%2.7%4.8%-1.4%0.3%-2.9%4.0%-0.3%3.6%
20066.1%0.3%3.4%0.1%-4.2%0.1%-2.2%2.0%0.5%4.3%2.1%0.1%12.7%
20071.4%-0.4%0.7%1.5%3.2%-1.1%-5.0%1.5%1.3%2.4%-5.2%-0.4%-0.5%
2008-7.2%-2.3%-0.0%4.2%4.1%-8.2%0.8%1.9%-9.5%-22.0%-10.4%5.5%-38.1%
2009-10.1%-11.4%8.7%15.8%6.9%1.6%9.0%4.2%5.5%-5.3%2.6%6.0%34.3%
2010-3.3%3.3%7.9%4.2%-8.5%-6.0%7.7%-6.5%12.2%4.2%1.6%8.6%25.7%
20110.1%4.6%1.9%3.6%-2.1%-2.0%-3.1%-8.5%-11.1%13.2%-0.9%-0.5%-6.7%
20127.6%3.4%1.9%-1.3%-7.9%4.7%-1.2%3.5%3.3%-1.3%1.0%3.6%17.9%
20135.9%1.2%4.1%0.7%2.0%-1.4%7.3%-2.6%6.9%2.7%2.9%2.4%36.8%
2014-2.5%5.2%-0.7%-2.6%1.1%4.3%-5.0%3.9%-5.5%4.4%0.2%1.7%3.9%
2015-2.2%6.5%0.9%-0.6%2.2%-0.2%-0.2%-5.9%-4.3%5.7%2.2%-3.7%-0.4%
2016-7.9%-0.3%8.2%1.5%2.0%-1.2%5.5%1.0%1.4%-4.1%7.0%2.3%15.2%
20171.6%2.1%0.7%1.9%-0.4%2.4%1.6%-0.5%4.8%1.2%2.4%0.8%20.3%
20183.4%-3.8%0.8%0.6%4.0%-0.1%1.8%3.0%-1.8%-10.7%1.4%-10.6%-12.6%
201910.5%4.4%-1.2%3.4%-7.3%6.4%0.3%-4.1%2.0%2.9%3.7%3.0%25.3%
2020-2.8%-8.7%-21.0%13.0%7.3%2.9%3.1%5.8%-2.3%0.6%16.6%8.0%18.1%
20212.8%5.3%1.6%2.9%0.5%0.8%-1.9%2.2%-3.3%4.0%-4.5%2.9%13.8%
2022-8.4%0.0%0.7%-8.8%0.3%-8.9%9.5%-2.9%-9.9%9.4%5.1%-4.9%-19.3%
20239.3%-2.1%-3.2%-0.4%-2.1%6.2%N/AN/AN/AN/AN/AN/A7.3%

Portfolio performance statistics:

Statistical MetricValue
Annual Return %7.04%
Risk-Adjusted Return %7.42%
Max. drawdown-59.26%
CAR/MaxDD0.12
Standard Deviation24.39%
Sharpe Ratio (3% risk-free)0.16

Performance stats per ETF since inception:

TickerExposure %CARRARMax. Sys % DrawdownCAR/MDDAnual Standard Deviation (%)Sharpe Ratio (3% Risk-Free Rate)
VBR96.837.988.24-62.010.1326.30.19
IWM99.987.627.62-58.640.1327.490.16
IWO99.985.825.82-60.10.129.010.1
SCZ99.653.673.68-61.170.0624.390.03

The Mid- and Large-Cap Stock Portfolio

Let’s also create a portfolio of mid- and large-cap stocks whose historical performance will be used to compare with the performance of the small-cap stock portfolio:

Asset CategoryETF NameETF TickerWeight
Large-, Mid-Cap BlendSPDR S&P 500 ETF TrustSPY25%
Large-, Mid-Cap ValueVanguard Value Index FundVTV25%
Large-, Mid-Cap GrowthInvesco QQQ TrustQQQ25%
Large-, Mid-Cap International BlendiShares MSCI EAFE ETFEFA25%

Backtesing Of The Large-Cap Stock Portfolio

Let’s backtest the Large-Cap Stock Portfolio under the same conditions as we backtested the Small-Cap Stock portfolio:

Portfolio equity curve of the backtest:

Small cap vs. large cap performance

The portfolio’s underwater curve (drawdowns, i.e., decline in value from a relative peak value to a relative trough):

Small cap strategy losses and drawdowns

Portfolio monthly and annual returns:

YearJanFebMarAprMayJunJulAugSepOctNovDecYr%
20041.2%1.2%-1.2%-2.5%2.1%2.7%-4.1%0.1%1.9%2.8%5.3%3.6%13.5%
2005-3.1%2.2%-2.0%-2.3%3.3%-0.1%4.2%0.2%1.9%-2.4%4.0%1.0%6.7%
20063.8%-0.4%2.3%2.1%-4.1%0.3%-0.0%2.7%2.3%3.7%2.6%1.4%17.8%
20071.4%-1.3%1.6%4.5%3.1%-0.8%-2.6%1.2%4.5%3.3%-4.9%-1.4%8.5%
2008-7.6%-3.1%0.2%5.6%2.0%-9.1%-0.9%0.1%-10.9%-17.2%-7.9%3.2%-38.9%
2009-8.9%-9.9%8.9%11.4%7.1%0.2%8.5%3.6%4.1%-2.6%5.6%2.4%31.9%
2010-4.4%2.7%6.6%0.7%-8.5%-4.7%8.0%-4.4%9.9%4.2%-1.4%6.9%14.5%
20112.5%3.6%-0.7%3.6%-1.5%-1.8%-1.6%-6.3%-7.2%10.3%-1.5%0.2%-1.4%
20125.4%4.9%2.9%-1.2%-7.5%4.8%0.9%3.1%2.2%-1.7%1.0%1.7%17.0%
20134.5%0.4%3.1%2.9%1.4%-1.8%5.5%-2.3%4.5%4.4%2.6%2.5%30.8%
2014-3.6%4.9%0.1%0.7%2.4%2.0%-1.0%3.2%-1.8%1.7%2.6%-1.5%9.9%
2015-2.1%6.1%-1.7%2.0%1.2%-2.5%2.5%-6.6%-2.9%8.6%0.2%-1.7%2.2%
2016-5.6%-1.2%6.7%0.2%1.7%-0.8%4.4%0.6%0.8%-1.6%2.1%2.1%9.4%
20172.7%3.3%1.1%1.6%2.3%0.0%2.6%0.5%1.7%2.7%2.3%1.2%24.1%
20186.1%-3.5%-2.6%0.7%1.7%0.1%3.5%2.3%0.4%-7.2%1.3%-8.1%-6.0%
20197.7%2.9%1.8%4.0%-6.5%6.9%0.7%-2.1%2.3%3.0%3.1%3.1%29.5%
2020-0.6%-7.8%-12.1%11.2%5.0%2.8%4.9%7.1%-3.7%-2.8%12.1%4.3%19.1%
2021-0.6%2.5%3.9%4.4%1.5%1.5%1.8%2.7%-4.4%5.9%-1.5%4.2%23.5%
2022-4.7%-3.0%3.0%-8.4%0.9%-8.4%7.8%-4.4%-9.1%7.7%7.5%-4.7%-16.8%
20237.2%-2.3%4.1%1.7%0.3%5.0%N/AN/AN/AN/AN/AN/A16.8%

Portfolio performance statistics compared to the Small-Cap Portfolio stats:

Statistical MetricSmall-Cap PortfolioLarge-Cap Portfolio
Annual Return %7.04%9.37%
Risk-Adjusted Return %7.42%9.38%
Max. drawdown-59.26%-56.66%
CAR/MaxDD0.120.17
Standard Deviation24.39%21.39%
Sharpe Ratio (3% risk-free)0.160.30

Performance stats per ETF since inception:

TickerExposure %CARRARMax. Sys % DrawdownCAR/MDDAnual Standard Deviation (%)Sharpe Ratio (3% Risk-Free Rate)
SPY99.999.859.85-55.190.1820.780.33
VTV99.988.368.36-59.270.1421.380.25
QQQ99.989.119.11-82.960.1131.830.19
EFA99.985.145.14-61.040.0823.950.09

Conclusion On The Small-Cap Effect Strategy

  • Our backtests have shown that over the last 20 years, from 2004 until today, small cap stocks have underperformed mid- and large-cap stocks;
  • Over the longer time period from 1963 to 2018, small-cap stocks have outperformed mid- and large-cap stocks except when volatility is extremely high;
  • The risk of high volatility might outweigh any benefits that small-cap stocks have;
  • You should invest in small-cap stocks with the lowest volatility possible to significantly outperform mid- and large-cap stocks.

FAQ:

Why might smaller companies outperform larger ones in the stock market?

Smaller companies may outperform larger ones due to their greater growth potential, agility in responding to market changes, and the possibility of being undervalued. The small-cap effect is often attributed to factors like less analyst coverage and institutional attention, leading to potential opportunities for investors.

What are the advantages of investing in small-cap stocks?

Some advantages of small-cap stocks include their potential for high returns, business diversity across various industries, and the opportunity to invest in less popular, potentially undervalued companies. However, it’s important to note that investing in small caps comes with higher volatility and risks.

Do small caps or large caps perform better in recessions?

Large-cap stocks tend to perform better in recessions, as investors often prioritize safety and liquidity during economic downturns. Small-cap stocks, being more sensitive to economic conditions, may experience greater volatility and sell-offs during recessions, presenting opportunities for investors to buy at lower valuations.

Similar Posts