One of the most important findings of modern finance is that small companies, on average, have higher returns than large companies. This size premium is evident from the following graph which illustrates the growth of $1.00 U.S. invested in small company stocks (in red) compared to large company stocks (in green) from January 1926 to November 2009.
The investment in small company stocks grew to $11,253 - more than four times the $2,537 of the large company stocks.
The size premium is not restricted to the United States. A number of researchers have confirmed its presence in most other countries around the world. In a study spanning seventeen countries, Hawawini and Keim found that small company stocks outperformed large company stocks in every country except Korea.
The size premium is unique in a number of respects. First, the relationship between return and size applies across the complete spectrum of firm sizes. Returns become progressively higher as one moves from large to medium to small to micro companies (see Table I at the end of the Commentary). Risk also grows commensurately since the smallest stocks are more than twice as volatile as the largest stocks.
Second, the size premium is a highly streaky phenomenon. The following graph, which depicts the cumulative size premium (i.e. small company returns – large company returns) since 1926, shows that outperformance by small company stocks was concentrated in the mid-1930's, the early to mid-1940's, the late 1960's, the mid-1970's to early 1980's, the early 1990's and the earlier part of this decade.
As can be seen, the periods of outperformance by small company stocks have frequently been punctuated by lengthy spans of underperformance. Accessing the size premium therefore requires patience.
One of the more remarkable elements of this firm size effect is that it seasonal. Virtually the entire size premium occurs in January, an outsized month for small company returns. This excess performance is evidenced in the following bar graph which depicts the average monthly return of U.S. small company stocks from 1926-2008.
Source: Tacita Capital, based on Ibbotson Associates SBBI Small Company Stocks
40% of the average annual return of small company stocks has occurred in January. Two theories have been advanced for this "January effect". The first attributes the effect to tax-loss selling where losers that were disposed of in the prior year are re-acquired bidding up prices in January. The second attributes the effect year-end "window-dressing" by fund managers who rid their portfolios of losing stocks before year-end thereby depressing prices which bounce back in January.
One of the enduring myths about small company stocks is that they represent a spectrum of the market where, on average, active managers add value by outperforming small company indexes. The evidence refutes this belief. In a comprehensive study
of U.S. mutual funds from 1965-1998, Davis found no evidence of positive, abnormal returns in actively managed small stock funds. More recently, Standard & Poor's found that small stock funds as a group underperformed their benchmarks in both of the past five-year market cycles including the bear markets (see Table II at the end of the Commentary).
Small company stocks offer patient investors an opportunity to enhance performance. Their "streakiness", however, means that a strategic, long-term commitment is essential to realizing on this opportunity. Also, given the volatility of this asset class, portfolio allocations must be consistent with the risk profile of the individual investor. This isn't a free lunch – extra helpings bring extra risk.
December 17, 2009
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Table I |
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Size-Decile Portfolios of the NYSE/AMEX/NASDAQ |
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Summary of Annual Returns in Percents 1926-2008 |
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|
Geometric |
Arithmetic |
Standard |
|
|
Decile |
Mean |
Mean |
Deviation |
| 1-Largest |
8.9% |
10.8% |
19.48% |
|
2 |
10.1 |
12.5 |
22.33 |
|
3 |
10.4 |
13.1 |
23.89 |
|
4 |
10.4 |
13.4 |
26.13 |
|
5 |
10.9 |
14.2 |
26.90 |
|
6 |
10.9 |
14.5 |
27.59 |
|
7 |
10.8 |
14.8 |
29.82 |
|
8 |
11.0 |
16.0 |
34.44 |
|
9 |
11.1 |
16.6 |
36.70 |
| 10 - Smallest |
12.5 |
20.1 |
44.95 |
Source: Ibbotson SBBI 2009 Classic Yearbook
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Table II |
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Percent of Active Funds Outperformed by Benchmarks |
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|
1999-2003 |
2004-2008 |
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| Small Core |
62.9% |
81.4% |
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| Small Growth |
69.9 |
95.6 |
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| Small Value |
62.0 |
69.5 |
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Source: SPIVA Scorecard: Active Management Myths;
http://www2.standardandpoors.com/spf/pdf/index/SPIVA_2009_UPDATE.pdf
Tacita Capital Inc. ("Tacita") is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services to families of affluence. We understand the challenges of affluence and apply the leading research and best practices of top financial academics and industry practitioners in assisting our clients reach their goals.
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