Small-Caps Investing as Performance Booster? THE TRUTH EXPOSED

Small-Caps Investing as Performance Booster

For decades now, many investors have bought into the idea of a Small-Cap premium, so the assumption is that Small-Caps stocks outperform the total stock market. But what exactly are Small-Caps? What are the risks of investing in them? And is it true that they outperform the market? These are the questions that we will answer in this article. And at the very end, I will show you 4 super simple ways to invest in Small-Caps yourself

Small-Cap Explained

Before we start, let’s quickly look at what Small-Cap actually means. And that’s where it gets tricky: There is no standardized definition of what Small-Cap actually means. It’s up to each index provider to decide which companies to include as Small-Cap. Usually, the stock market is divided into 3 “Caps” when it comes to company sizes: The largest and most valuable ones are Large-Caps, so companies like Apple, Amazon, and so on. Then we have the Mid-Caps and the smallest ones are Small-Caps. Some people add 2 more “Caps”: Mega-Caps for the few largest companies and the Micro-Cap for companies that are even smaller than Small-Caps.

Small-Caps Investing

To put each company in the right “Cap”, you start looking at their market cap. Market cap is the total market value of a company. You can easily calculate it by taking a company’s current share price and multiplying it by the total number of shares outstanding. So each index provider has a different definition of Small-Caps. Let’s have a look at one of the most famous ones: Standard & Poor’s and their S&P 600 Index. And it all starts with the S&P 1,500 Index. This one includes the 1,500 largest US stocks by market cap and covers 90% of the investable US stock market.

Standard & Poor’s then breaks these 1,500 stocks into Large-, Mid- and Small-Caps. The most valuable 500 companies are part of the S&P 500 – the most commonly used index globally. The 400 next biggest companies by market cap are part of the S&P 400, which is their Mid-Cap Index. And the 600 next largest companies after that are part of the S&P 600 which is their Small-Cap Index.

Another very common Small-Cap index is the Russell 2000 Index. You might have heard of the Russell 3000 Index, which includes the 3,000 largest US stocks and covers 97% of the investable US stock market. The Russell 2000 Index only takes the smallest 2,000 stocks of the Russell 3000. So the first 2 indexes we looked at are based on a set number of stocks, 600 for the S&P 600 and 2,000 for the Russell 2000.

Small-Cap Investing

Let’s also have a look at MSCI and their All-Country World Index, also known as ACWI. They take a bit of a different approach here. They also rank all stocks by market cap and separate them into different caps – but by percentage and not by a set number of stocks. Large-Caps have the highest share with 70%, followed by Mid-Caps with the next highest 15% of market cap. Then we have Small-Caps which include the next highest 14% of market cap. And lastly Micro-Caps with the remaining 1%. So as you can see, each index provider has its own definition of Small-Caps.

How small are Small-Caps really?

Let’s have a look at the 3 indexes we just looked at The S&P 600, the Russell 2000, and the MSCI ACWI Small-Cap Index. The most valuable company on the S&P 600 has a market cap of over $6bn and the smallest one is just below $100m. The largest one of the Russell 2000 has a market cap of $11bn and the smallest one is $20m. With the MSCI ACWI Small-Cap Index, the largest stock has a market cap of $17bn. So as you can see: Small-Caps are not always the same and can range from anywhere between $17bn and $20m.

Small-Cap Investing

Pros and Cons of Small-Cap Investing

There are a few reasons why investing in Small-Cap ETFs can be a smart addition to your portfolio. One obvious advantage is growth potential. Most Mega-Caps that dominate the S&P 500 today started off as small businesses. Small-cap investing gives you a chance to get into a stock early on and ride the wave to the top. Another advantage is that Small-Caps can give you a diversification booster! Most US and global ETFs focus on Large-Caps only.

So investing in an additional ETF that only focuses on Small-Caps can increase your diversification because you will get very few overlaps. Also, most Small-Cap ETFs hold thousands of stocks which will instantly increase the number of stocks that you are invested in. But as always, there are also some risks associated with Small-Cap investing.

The first one: Volatility. Small-Caps are more volatile. So their share price moves up and down stronger than Large-Caps – which is great during bull markets but can hurt investors in a crash.

Next up: Liquidity risk. Small-Caps have less liquidity which means that they are traded less frequently than Mega-Caps like Apple whose shares are traded 100 million times per day. Small-Caps are not traded as frequently which means that there can be a bigger spread between the buy and sell prices.

And lastly, Small-Caps are less transparent. There is simply less information available compared to the huge investor relations section of companies like Amazon for example. So Small-Cap investors need to do a bit more digging work to find information.

Performance since 1999

Small-Cap Investing

Alright, we understand the benefits and risks. But how have Small-Caps actually performed against the market? Let’s compare the Vanguard Small-Cap Index Fund in blue against the SPY ETF which tracks the S&P 500 in red. I got this data from portfoliovisualizer.com The data goes from 1999 to 2022, so over a time frame of over 20 years.

And you can see that the Small-Cap Index in blue has massively outperformed the S&P 500 Index by 2% per year. What you can also see is that Small-Caps are more volatile. The best year had a return of 45% versus 32% for the S&P 500, but their biggest drawdown was also harder with 53% versus 50% for the S&P 500. So a higher performance coupled with a higher risk means that the risk-adjusted return, also known as the Sharpe ratio is slightly lower for the Small-Cap index with 0.45 versus 0.48 for the S&P 500.

So are Small-Caps the better investment that can give you a consistent outperformance? For decades now, analysts and investors have accepted the theory of the Small-Cap premium, which means that you can expect higher returns from Small-Caps compared to the total stock market. The first studies that discovered the Small-Cap premium were published back in the 1970s.

Fama and French narrowed this down even more in their Nobel prize-winning strategy in 1993. So there is a lot of scientific evidence that suggests that investing in Small-Caps comes with a nice premium. So wouldn’t it make sense then to just invest all your money in Small-Caps and forget about S&P 500 or other Large-Cap ETFs? Not so fast! Let’s look at some numbers here.

Small-Cap Premium

Small-Cap Premium

In the last 20 years, the S&P 500 could generate an annual return of 9.1% whilst Vanguard’s Small-Cap ETF from before could generate 9.8% per year, so 0.7% more – nice! If we look at the last 15 years, the S&P 500 would have gotten you an annual return of 10.1% whilst the return of the Small-Cap ETF was 9.1%, so 1% lower. In the last 10 years, that gap has become even bigger. The S&P 500 would have gotten you an annual return of 15.7% whilst the Small-Cap ETF only returned 13.0%, so 2.7% less per year.

In the last 5 years, that gap has widened to 5.5%. So yes, historically there was a Small-Cap premium. But like any factor premium in the stock market, there is no guarantee for a consistent outperformance. There can be years and even decades where Small-Caps will outperform or underperform the market. We can also see that the trend right now is going down.

What started off as an annual outperformance of 0.7% has gone down to an annual underperformance of 5.5%. And we simply don’t know if that trend will continue or if there will be a comeback of Small-Caps.

4 Ways to Invest in Small-Caps

If you still like the idea of Small-Cap investing and you want to use it as a satellite in your Core-Satellite portfolio, then you could go for an ETF. And you are spoiled for choice here: There are more than 100 Small-Cap ETFs out there.

1. The first ETF you could go for is the iShares Core S&P Small-Cap ETF, ticker symbol IJR. It’s one of the oldest, biggest, simplest, and cheapest ETFs out there. It tracks the S&P 600 Index that we looked at at the beginning of the article.

2. Another option would be the Vanguard Small-Cap Growth ETF, ticker symbol VBK. And the special feature of this one is that it combines Small-Cap with growth investing.

3. If you want to combine Small-Cap investing with ESG, then you could go for the iShares ESG Aware MSCI USA Small-Cap ETF, ticker symbol ESML.

4. And for everyone who wants to go global, there is the iShares MSCI EAFE Small-Cap ETF, ticker symbol SCZ.

Video Credit: Yahoo Finance

Conclusion

There you have it: Small-Caps, their benefits, and risks, and how to invest in them. Historically, Small-Caps could give investors a premium compared to the market, but that trend has gone negative in the last few years. The thing with premiums is: They can work for a given time, but there is no such thing as a factor premium that consistently beats the market. But what do you actually think? Are you investing in Small-Caps? Will they revert the trend and outperform the market in the next few years to come? As always – let me know in the comment section below.

Disclaimer: This article is solely for educational purposes and contains only my personal opinion. To make the best financial decision for your own needs, you must conduct thorough research and, if necessary, seek the advice of a licensed financial advisor.

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