December 17, 2009One 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 in 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 - 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 returns 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 to “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 investor. This isn’t a free lunch – extra helpings bring extra risk.
December 17, 2009
Source: Ibbotson SBBI 2009 Classic Yearbook
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.
Tacita research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it and is not intended to replace individually tailored investment advice. The asset classes/securities/instruments/strategies discussed may not be suitable for all investors and certain investors may not be eligible to purchase or participate in some or all of them. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Tacita recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor.
Tacita research is prepared for informational purposes. Neither the information nor any opinion expressed constitutes a solicitation by Tacita for the purchase or sale of any securities or financial products. This research is not intended to provide tax, legal, or accounting advice and readers are advised to seek out qualified professionals that provide advice on these issues for their individual circumstances.
Tacita research is based on public information. Tacita makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to inform any parties when opinions, estimates or information in Tacita research changes.
All investments involve risk including loss of principal. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. Management fees and expenses are associated with investing. -------------------------
Hawawini, G. and D.B. Keim, 2000, “The cross section of common stock returns: a review of the evidence and some new findings, in Keim, D.B., and W.T. Ziemba (Eds) Security Market Imperfections in World Wide Equity Markets. Cambridge:Cambridge University Press.
Davis, J. L., 2001, “Mutual fund performance and manager style”, Financial Analysts Journal, Vol. 57, No. 1, p.19-27.
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