small cap effect investment strategy

Small-Cap Effect Trading Strategy (Factor, Backtest, Performance, Setup)

Of the many classifications a stock can have, one of the most significant is relative to its size. It is well known in the market that small caps tend to perform better than large caps, something called the small-cap effect. However, how significant is the small-cap factor?

In this article, we are going to explore what the small-cap effect is, develop some trading strategies, and backtest them. We also remind you that we have backtested other factor investing strategies.

What is the small-cap effect (factor)?

The small-cap effect, also known as the small-cap premium, is a phenomenon that suggests that smaller companies tend to outperform larger companies over the long term. This effect is a key component of the Fama-French three-factor model, which attempts to explain stock returns based on various factors.

However, small-caps can be divided into volatile and non-volatile stocks (another factor). It turns out that volatile small-caps have not made money since JFK was president, while low-volatility small-cap stocks have been the best investment. We covered this in our article about the low volatility factor. The table below shows the different returns since 1963 for the different market caps and volatility:

Small cap effect trading strategy
Small cap effect trading strategy

The small-cap effect is typically associated with the following characteristics of small-cap stocks:

  • Higher Historical Returns: Small-cap stocks have historically shown higher average returns compared to large-cap stocks. Investors often attribute this to the greater growth potential and risk associated with smaller, less-established companies.
  • Greater Risk: While small-cap stocks have the potential for higher returns, they are also considered riskier investments. They can be more volatile and less liquid than large-cap stocks, making them subject to larger price swings. However, please keep in mind the table above.
  • Market Inefficiencies: Some experts argue that the small-cap effect may result from market inefficiencies. Smaller companies may receive less attention from analysts and institutional investors, leading to mispricing and opportunities for savvy investors.
  • Economic Sensitivity: Small-cap stocks are often more sensitive to changes in the domestic economy, as they may have limited international exposure compared to large-cap multinational corporations.

So in practice (and theory), small-caps perform really well. Now it’s time to backtest some trading strategies.

Small-cap effect trading strategy – backtest

For the backtest, we decided to use the portfolios calculated by French and Fama, and instead of backtesting just small caps in general, we paired them up with other factors.

The first one is formed based on size and book-to-market (value) at the end of each June using NYSE breakpoints. The book-to-market ratio for June of year t is the book equity to market equity for the last fiscal year ending in t-1.

Here is the equity curve of the three portfolios sorted by size and value:

Small value factor performance
Small value factor performance

The returns look really good! Here are some performance metrics and statistics:

St Deviation28.1924.2525.98
Max Drawdown-88.60%-85.79%-88.56%
$100 Becomes$30.268.299,10$9.117.061,49$306.653,57

The CAGR is really impressive, but not everyone is capable of supporting a ~90% drawdown and a standard deviation of nearly 30. Most traders and investors would fold.

The next portfolios we are going to backtest are formed based on size and quality. These portfolios are formed by profitability at the end of each June using NYSE breakpoints.

Profitability for June of year t is calculated as annual revenues minus the cost of goods sold, interest expense, and selling, general, and administrative expenses, divided by book equity for the last fiscal year ending in t-1. Here is how this factor performed:

Small quality factor performance
Small quality factor performance

The returns look very solid as well. Here are the performance metrics:

St Deviation21.2418.5322.75
Max Drawdown-62.02%-54.32%-61.94%
$100 Becomes$276.063,67$217.675,96$24.184,31

The small-robust portfolio has the same CAGR as small-value but much less volatility and maximum drawdown (although this backtest did not include the great deprecession in the 1930s).

Lastly, we are going to backtest the portfolios based on size and investment. Investment is the change in total assets from the fiscal year ending in year t-2 to the fiscal year ending in t-1, divided by t-2 total assets. Here are the compounded returns:

Small-cap effect
Small-cap effect

Not bad either. Here are some statistics about the strategy:

St Deviation22.6918.2921.30
Max Drawdown-74.55%-51.68%-57.99%
$100 Becomes$17.261,41$334.949,55$333.260,67

Companies that don’t grow their assets much seem to perform much better than those that do.

Small cap effect trading strategy – conclusion

To sum up, today you learned about the small-cap effect in stocks and we conducted three backtests on some small-cap trading strategies. As you can see, small caps performed exceptionally well when sorted by value, quality, and investment.

However, combining two factors, such as value and quality or value and investment, could potentially lead to even more significant improvements in results.

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