|The Size Effect Factor
Modifying the Capital Asset Pricing Model (CAPM), which bases estimated asset’s returns on a single factor, the market return (systematic risk), many academic studies, led by Fama and French, have shown that the addition of two extra factors better explains an asset’s return: Size and Value.
The size factor states that a large part of equity portfolios’ outperformance comes from the liquidity premium, which compensates higher liquidity risk. Indeed, the lower your market capitalization, the lower your liquidity. Since 1998, the S&P Small-Cap 600 index has outperformed the S&P 500 by 167% in total.
|Is the Size Effect a time period anomaly?
The bulk of small-cap outperformance in the 1970s and 1980s has come in post-recession recovery periods. Indeed, overall a number of studies have noted that the small-cap effect has weakened over the past 20 years.
Part of the outperformance of small-caps can be attributed to their higher volatility versus large-caps, and their higher economic sensitivity. This would explain small-cap strength post recessionary periods – the so-called “junk” effect.
Small-cap outperformance versus large-cap cyclical stocks is a much lower 1.5% per year.
|A Bigger Size Effect in Less Efficient Markets?
In Europe, the small-cap effect has been much more rewarding than in the US; since 2002, European small-caps have delivered 4.5% more on average per year than large-caps, a far greater small-cap premium.
This could be due to the fact that liquidity is lower for European small-caps versus their US small-cap peers, leading to greater inefficiency of market pricing.
Added to this is the lack of a single accounting standard throughout Europe, differing reporting periods and of course reporting in different languages.
|What is Better: Mid- or Small-Cap?
Since 1998, US mid-caps (the S&P Mid 400 index) have beaten small-caps by an aggregate 102%, or by an average of 1.3% per year.
This was also achieved at a lower realised volatility level, of 18.2% for mid-caps versus a higher 19.5% for small-caps. Thus on a risk-adjusted basis, Mid-caps were clearly the far better choice.
Both mid- and small-cap indices remain more domestically-oriented than the S&P 500, and more heavily biased towards the Industrial and Financial sectors, while much lower in Energy and Consumer Staples (Food, Beverages, Household Goods).
|UK Mid-Caps Have Been Very Impressive
One of our favourite UK-centric index strategies has been UK mid-caps, in the form of the FTSE 250 index representing the 250 largest UK companies below the top 100 (FTSE 100).
The FTSE 250 has posted a Compound Annual Growth Rate of 10.9% p.a. with dividends since 1996, far above the FTSE Small-Cap index (7.2%) and the FTSE 100 (6.8%).
By sector, the FTSE 250 is overweight in Industrials and Consumer Discretionary stocks with comparison to the FTSE 100, which has higher weightings in Energy, Healthcare and Consumer Staples.
|iShares Euro STOXX Small ETF (DJSC NA)
The iShares Euro STOXX Small ETF is an ETF that tracks the Euro STOXX Small index (SCXE), the smallest 94 members out of the 292-member Euro STOXX Large index (SXXE).
Major sector weightings: Financials (28%), Industrials (20%) and Consumer Discretionary (19%).
This ETF is listed on the London Stock Exchange, Euronext Amsterdam and Deutsche Boerse, ensuring good levels of liquidity.
Interestingly, since launch in 2004 this ETF has actually slightly outperformed the Euro STOXX Small benchmark, at +8.39% versus +8.22% for the underlying index.
|Sources: FTSE, S&P DJ Indices, iShares and STOXX|
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