December 21, 2010
Small- to mid-cap stocks (smid-caps) have outperformed since 1999. The long-running outsized returns delivered by this market-cap segment have attracted considerable attention, and many wonder if it’s too late to add exposure to smaller stocks. Below, we offer a few things to consider in determining how much exposure to smid-cap stocks you should maintain.
Historical risk/return and correlation
Historically, smaller stocks have higher expected return and higher risk than their large-cap counterparts. Because they are not perfectly correlated to large stocks, however, adding small caps to your portfolio may enhance return but actually reduce overall risk. Modern portfolio theory tells us that the optimal portfolio is that which offers the best risk/return profile. Using that notion, an optimal mix may be 70% large-cap and 30% smid-cap stocks.
- Over the past 32 years, the small/midcap Russell 2500 Index has posted an annualized return of 13.81%, higher than the S&P 500’s annualized return of 11.94% and the small-cap Russell 2000 Index’ 12.83%.
- The annual standard deviation of the Russell 2500 Index return over the same period was 18.66%, versus 15.56% for the S&P 500 and 20.06 % for the Russell 2000 Index.)
- The Russell 2500 Index has a correlation with the S&P 500 of 0.88, and a near-perfect correlation of 0.99 with the Russell 2000:
|
Ann. Ret. | Ann. Risk | ||||||||||||||||||||
| S&P 500 | 11.94% | 15.56% | ||||||||||||||||||||
| Russell 2500 | 13.81% | 18.66% | ||||||||||||||||||||
| Russell 2000 | 12.83% | 20.06% | ||||||||||||||||||||
| Source: Standard & Poors, Russell Mellon, AIP Research | ||||||||||||||||||||||
| S&P 500 | Russell 2500 | Russell 2000 | ||||||||||||||||||||
| S&P 500 | 1.00 | |||||||||||||||||||||
| Russell 2500 | 0.88 | 1.00 | ||||||||||||||||||||
| Russell 2000 | 0.83 | 0.99 | 1.00 | |||||||||||||||||||
| Source: Standard & Poors, Russell Mellon, AIP Research | ||||||||||||||||||||||
Efficient frontier and optimal asset allocation
Because the Russell 2500 Index boasts superior returns to both the Russell 2000 Index and the S&P 500 Index, and because the benchmark has less-than-perfect correlation with the large-cap S&P 500 Index, a blended portfolio of large- and smid-cap stocks dominates both a pure large-cap portfolio and a blended portfolio of large-cap and small-cap stocks:
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