Don't Overlook Quality in Small-Cap Investing

The conventional wisdom is that risk-adjusted, overall portfolio returns are enhanced by combining exposure to a U.S. small-cap equity benchmark, like the Russell 2000 Index, with large-cap stocks. However, we find this belief is simply not supported by the data.

Based on our analysis, the small-cap "risk premium" first identified in the early 1980s still holds -- but only for "quality" small caps.

So, when considering small caps, we believe investors should focus on quality if they want to get the most from this distinctive asset class.

What premium?

Let's start with a look at the past decade and the 1-, 3-, 5- and 10-year annualized returns for the small-cap Russell 2000 vs. the large-cap Russell 1000. Only for the 10-year period have small caps outperformed large caps. Yet, even for this 10-year period of outperformance, the return was insufficient to account for higher risk -- small caps had a higher standard deviation (25.45% vs. 20.26%) and a lower Sharpe ratio (0.37 vs. 0.45).

So, over the past decade, risk-adjusted performance suggests that small-cap stocks haven't delivered vs. large caps. We believe this can be explained by the declining quality of stocks in the Russell 2000, which is why we also believe active management and a focus on quality are critical when investing in U.S. small caps.

Benchmark blues

Intuitively, the small-cap universe should offer the potential for higher returns, along with opportunities to capitalize on inefficiencies. Smaller companies often have higher growth rates, insider ownership, and can be acquisition targets.