Small is beautiful.
Illustration: Erin O’Leary Brown. Source: Web-esl.com
Positive skewness makes it hard to beat large cap stock indices, especially in bull markets. You have to hitch your wagon to a rising star and keep going—ignoring all those nasty risk-management nannies that say diversify, diversify. The growth darlings seem to defy gravity, and it appears that there is almost nothing that can stop them. So should stock-pickers just give up?
Fortunately, large-cap stocks aren’t the only asset-class in town. Other assets display negative skewness, like bonds. Their index is pulled down by just a few junky issues. If you avoid them, you can do better than the index. Also, large-cap stocks aren’t the only equity sandbox in the asset-allocation playground. There’s also small-cap stocks, for example.
Small cap stocks generally outperform large caps because of the risk inherent in small-cap investing. Smaller companies go out of business more easily, they have fewer resources available to them, it’s harder for them to access the capital markets, and so on. So their indices tend to do better than large caps, over the long run, although they’re more volatile.
Source: Probity Advisors
If you go back 90 years, a dollar invested in small cap stocks would have grown to $27 thousand, while a large-cap dollar would only be $5 thousand. Except, maybe not. There were long periods where small caps just kept even with large caps, or even lagged behind. The ‘50s and ‘60s were examples. Most small cap excess return happened in the ‘70s and early ‘80s—just before it was discovered and reported by financial economists.
And over the last 20 years, small caps have appeared less risky than large caps, while keeping up with them, on average. What’s going on?
Blue: S&P 500; Orange: S&P Small Cap. Source: Bloomberg
The issue has to do with skewness, again. Small cap indices don’t have positive skewness. If an issue gets so big that it dominates the index, it gets “kicked upstairs” into the mid cap or large cap index. But they are negatively skewed. Junky small companies pull down the index’s performance, and keep it from doing as well as it might—just like bad credits pull down a bond index. One fund manager put it this way: “Size matters, if you control your junk.”
Investment management is a continual process of hunting for undiscovered gems while avoiding overpriced bums. Small may be beautiful, but when it also has quality, it’s gorgeous.
Douglas R. Tengdin, CFA