The Small Cap Falsehood

The supposed outperformance of small cap stocks is a foundational precept on which many respected asset managers have staked their expertise over the years – foremost among them, Dimensional Fund Advisors (DFA), the famed fund company that has gained a near-religious following since they popularized small cap indexing three decades ago. A growing body of research, however, shows no such advantage for the last 30 years and, now, a new study seems to have proven that the supposed small-cap advantage may have never existed in the first place.

The paper, which appeared in September in Financial Advisor Magazine, was written by Gary A. Miller and Scott A. MacKillop of Wyoming-based Frontier Asset Management, and it began with this startling claim:

“The results show that, in the 1936-1975 period, the common stock of small firms had, on average, higher risk-adjusted returns than the common stock of larger firms.” That one sentence, which appeared in a paper by Rolf Banz published in the Journal of Financial Economics in 1981, is the foundation for the investment truism, “Small stocks beat large stocks.” As it turns out, Banz was wrong.

And MacKillop and Miller are right, as my own analysis confirms. As we shall see, not only was Banz wrong but so, later, were Eugene Fama and Kenneth French, as well as a number of others who have asserted expertise on this subject.

The “science” of investing

The truism that small caps beat large stocks has been one of the foremost reasons advanced to explain the success of DFA, the firm that first created and marketed small-stock index funds. I hadn’t looked at DFA’s website in a while, so I decided to check it out.

The first thing I saw was a prominent photo of Nobel laureate Robert C. Merton, identifying him as “Resident Scientist.” A link on the page invites you to take a tour of the website. I clicked it. The second sentence on the next page says, “Over the years, we have translated financial science into real world investment solutions.” Reading further, I found that the word “science,” especially in the combination “financial science,” is all over the site.

Hogwash. Finance is not a science. Investment experts who serve a tour of duty in a financial firm, no matter how many Nobel prizes they have won, are not scientists.

How little they are scientists we shall soon see. But first, a bit of history.

The origins of DFA

In the early 1970s the idea of passive investing and indexing began to take hold among financial academicians and in-the-know institutional investors, because a growing body of literature showed that active investing added nothing to performance – and subtracted its fees.

The first institutional index fund, a Samsonite Corporation pension fund with only $6 million invested, was managed by Wells Fargo. The managers found it too difficult to include all stocks in a value-weighted index fund – some of them would have had only a few dollars or even pennies invested in them – so they decided to index the Standard & Poors 500 stocks. The idea of indexing to the S&P 500 stuck – so much so that many people today still think that indexing means to hold a value-weighted portfolio of the S&P 500. In the early 1970s, several managers began to manage S&P 500 index funds, including Vanguard.