- Stocks of small companies have higher incidences of price volatility and mispricing, increasing opportunities for investors to earn excess returns.
- Implementing outperforming strategies, such as value or momentum, in the small-cap universe amplifies their alpha-generating potential.
- High trading costs of small-cap stocks require skilled execution and careful indexing rules for passive investing.
Although we live at the edge of the Pacific Ocean, our weekend adventures often take us inland to enjoy the lakes and streams of California and her neighboring states. A favorite pastime is fresh-water fishing. For most, the lure of fishing is a combination of serene beauty, contemplative quiet, and the satisfaction of reeling in as many big fish as possible. We admit that the first two attractions are very appealing in their restorative powers, particularly to office-weary asset managers, but we can’t help being most inspired by the basic challenge of catching a lot of big fish. The folklore claims 10% of fishermen catch 90% of the fish. What do the top 10% know that the others don’t?
Investors’ search for alpha is not dissimilar to the strategies of skilled and experienced fishermen. First, the skilled know the right location. They use multiple lines and hooks or lures to increase their opportunities. And they attract greater numbers of fish by chumming—adding scent or bait to the water. In the world of asset management, we can think of risk and mispricing as the chum that attracts alpha. Just as all fishing locations are not equal—contrast the teeming Lake Tahoe with the perishing Salton Sea—not all segments of the equity market are equal in the opportunities they present for finding alpha.
Small-Cap Alpha: Abundant, but Unreliable
Lake Tahoe is well known for both its abundance and diversity of fish. The academic literature has made a similar case for small stocks, often believed to be a deep pool into which an investor can cast her net and pull out a weighty haul of alpha.
Stocks of small companies vary significantly in price volatility, are more prone to defaults, and have high trading costs. In combination, these characteristics create an unpredictable risk distribution for small-cap stocks, and the same traits contribute to their frequently being mispriced. In addition, many known anomalies, or risk factors, have significantly higher return dispersion among small companies, creating numerous opportunities for alpha production.
Our research shows, however, that small stocks are not a dependable source of standalone premium. Granted, the small-cap universe is plentiful—there are thousands more small companies than large companies—and diverse—the U.S. economy encourages virtually any type of business or strategy an entrepreneur can envision—but these traits alone are insufficient to ensure small caps will unfailingly produce an excess return.
Many market participants believe that, just like value stocks outperform growth stocks, and positive momentum stocks outperform negative momentum stocks, small-cap stocks outperform large-cap stocks. In a recent article (Kalesnik and Beck, 2014), we discuss the evidence that supports the size premium. Table A1 in the appendix lists the main arguments in favor and against small size as a standalone source of premium. In our view, the arguments against are much stronger than the arguments in favor: we judge the evidence that small-cap companies, in general, outperform large-cap companies to be unreliable. Our advice to the equity investor is to examine that small cap you are considering to be sure it has the alpha-producing qualities you seek—if absent, toss that small fish back, and cast your line again.
Small caps are not the fish, they are the fishing spot—not the source of alpha, but rather a place where alpha can be found.
A Fertile Fishing Spot
Even if small companies are not as a group reliably outperforming large companies, small-cap stocks still hold significant promise for investors—they are a fertile fishing spot for alpha. Small caps, like other investment strategies, benefit from two potential sources of outperformance: 1) exposure to sources of risk that are compensated with higher returns, and 2) systematic sources of mispricing that can be exploited.
Small stocks come with higher risk than large stocks as measured by credit rating, delisting probability, and volatility. Table 1 reports the distress and volatility characteristics of U.S. stocks by size quintile. The S&P credit rating difference between small-cap stocks (B rated) and large-cap stocks (A+ rated) indicates the higher likelihood (over 200 times) of smaller stocks being delisted, often because of default. Small caps have a delisting rate of 2.38% versus 0.01% for large caps.