Small-Cap Effect

The small-cap effect refers to the long-term tendency of small-capitalization stocks to perform better than large-capitalization stocks.

As small-cap companies have a smaller operational and financial base, it’s easier for them to grow. They tend to do exceptionally well in an economic recovery because low-interest rates give them access to funds to invest in their growth. It is reasonable to assume that it is easier to increase sales to EUR 500 million than to EUR 50 billion, and in addition, smaller companies are more flexible and more adaptable.

However, they are also riskiest to invest in during economic crises as they don’t have the financial cushion to deal with such crises.

Larry Swedroe has in an article on the website www.advisorperspectives.com looked at the small-cap effect between 1998 and 2016.

Swedroe used passively managed funds as a proxy for both value and small-cap: Vanguard and Dimensional Fund Advisors (DFA).

These are managed 100% passively given their criteria. Value was in this case defined as low P / B. Here is the return for these two asset managers divided by their mandate (the name of the fund indicates what it is investing in):

Fund	Annualized Return	Volatility (%)	Sharpe Ratio
Vanguard Total Stock Market Index	6.4%	18.5%	0.31
Vanguard Value Index	6.1%	17.4%	0.33
DFA US Large Value III	7.8%	19.1%	0.42
Vanguard Small Cap Index	8.4%	20.5%	0.44
DFA US Small	9.3%	21.7%	0.48
DFA US Micro Cap	9.7%	22.9%	0.49
Vanguard Small Cap Value Index	8.9%	16.5%	0.51
DFA US Small Value	10.1%	22.9%	0.51
Non-US Developed Equities (MSCI EAFE Index)	3.6%	21.5%	0.18
DFA International Value	5.6%	23.3%	0.29
DFA International Small	8.1%	23.6%	0.41
DFA International Small Value	9.3%	24.2%	0.45
Non-US Emerging Equities (MSCI Emerging Markets Index)	7.4%	34.2%	0.36
Vanguard Emerging Markets Stock Index	7.4%	33.3%	0.35
DFA Emerging Markets	8.1%	33.7%	0.36
DFA Emerging Markets Value	10.8%	40.6%	0.4
DFA Emerging Markets Small	11.1	39.8%	0.42

It can be clearly seen from the table given above that both value and small-cap have higher returns for the US, international markets, and emerging markets.

However, small-cap stocks are less likely to pay dividends as they need all their capital to grow. Therefore, they are a better investment for those who don’t need fixed income from their portfolio.

The small-cap effect was first published by Eugen Fama and Roger French in 1992 called The Cross-Section of Expected Stock Returns.

They stated that there is a value discount (P / E, P / B, and P / CF) and a smallcap effect: Historical data show that small companies give better returns than large ones.

If we run a quick comparison of the S&P 500 (500 biggest companies) and S&P 100 (100 biggest companies), we’d see that the former has delivered a 2.34% better annual return than the S&P 100 in the last 40 years. This means that after 40 years, you’d have 2.5 times more capital with such a difference!