Factor Primer Series: Small-Cap

Returning to our series on factor investing (What is a Factor?), today we turn our attention to small-cap stocks. As a reminder, last time we defined factors as a source of excess return that is sensible, persistent over long time periods, pervasive across markets, and cost-effective to capture.

What is the Small Cap Factor? 

The small-cap factor is defined as the excess return of small-cap stocks relative to large-cap stocks. In more succinct terms, it’s that smaller stocks tend to outperform their larger peers over time. Like any investment strategy, this is not always the case, but if you wait long enough, smaller stocks have shown this to be true.

History of Small-Cap Research

In 1981, Rolf Banz (then at the University of Chicago) released his research on small-cap stocks and their long-term out performance¹. This was just the beginning of research into the small-cap factor, including its part in Eugene Fama and Ken French’s seminal Three-Factor model published in 1992².  Investors have been seeking to exploit this phenomenon since Professor Banz published his paper in 1981.

Why do small-caps stocks provide excess returns?

The outperformance of small-cap stocks can be explained both through market dynamics and behavioral dynamics. From a market perspective, small-cap stocks carry more risk and thus must pay a higher return for people to invest in them. This can be explained with a relatively easy example. If both Nike (a large company) and Crocs (a small company) had to go out to the market to get financing, who do you think would pay less? Nike, through its bulk and market share, would be able to negotiate better financing rates (all things being equal).  As a result, investors demand a better return from smaller, less established companies to compensate for the risk. On the behavioral side of the coin, many people invest in companies in which they are familiar, which is more often than not a large company with name recognition. Over long periods of time, this results in a systematic source of excess return, as demonstrated by the below chart.

Source: Ken French Data Library, Size quintiles based on decile-level information provided by Ken French. Returns are gross of transaction costs.  The Size Factor sorts US equities on market cap and organizes them in quintiles, returns are annualized.

The outperformance of small-caps over time doesn’t come free. Small-cap stocks are generally more volatile than larger stocks. While over the long run, you can get greater returns, there may be extended periods of underperformance. In nearly 70% of 10-year periods, small has outperformed large, but that still leaves the likelihood of long stretches of underperformance.

Source: Ken French Data Library. Small relative to large represents the 10-year annualized returns of the smallest 30 percent of the market less the 10-year annualized returns of the largest 30 percent of the market as provided in the Ken French Data Library. Returns are gross of transaction costs.

In order to dampen this volatility, it makes sense to implement the small factor in a well-diversified portfolio in the presence of other factors. BDF uses the small-cap factor in conjunction with three other factors, value, momentum and profitability, all of which diversify against each other. Up next month, we’ll be discussing the value factor, another factor with a proven history and caught up in the news recently.

¹ Banz, Rolf W., “The Relationship Between Return and Market Value of Common Stocks,” Journal of Financial Economics, Volume 9, Issue 1, March 1981.
² Fame, Eugene F.; French, Ken R., “The Cross-Section of Expected Stock Returns,” Journal of Finance, Volume 47, June 1992.