Small cap premium

Small cap premium is a concept within Portfolio theory and Investment strategies suggesting that, over long periods, stocks of companies with smaller market capitalization tend to outperform stocks of larger companies on a risk-adjusted basis. This observed excess return for smaller companies is considered a "premium" because investors theoretically demand higher returns for taking on the additional perceived market risk and liquidity risk often associated with smaller firms. The existence and persistence of the small cap premium have been subjects of extensive academic research and debate in financial markets.

History and Origin

The idea that smaller companies might offer higher returns than larger ones gained significant academic traction with the work of Rolf Banz in 1981, who observed what he termed the "size effect." This foundational research demonstrated that, historically, small-cap stocks had generated greater returns than predicted by the traditional Capital Asset Pricing Model (CAPM), which primarily accounts for systematic risk.²⁰

However, the concept was popularized and rigorously formalized by Nobel laureate Eugene Fama and Kenneth French in their influential 1992 paper, "The Cross-Section of Expected Stock Returns."¹⁹,¹⁸ They identified company size (market capitalization) as one of the key factors, along with a company's book-to-market ratio (value), that explained the cross-section of average stock returns, leading to the development of the Fama-French Three-Factor Model.¹⁷ This model posits that an investment's expected return is influenced not just by its overall market risk exposure but also by its exposure to the "size" factor (Small Minus Big, or SMB) and the "value" factor (High Minus Low, or HML). The SMB factor specifically represents the historical excess return of small-cap stocks over large-cap stocks.¹⁶ Dimensional Fund Advisors, a prominent asset management firm, explicitly states that the Fama-French factors form the foundation of their evidence-based investing approach.¹⁵,¹⁴

Key Takeaways

The small cap premium refers to the historically observed tendency for small-capitalization stocks to generate higher returns than large-capitalization stocks.
This premium is often attributed to the greater inherent risks and lower liquidity associated with smaller companies.
It is a key component of multi-factor investment models, most notably the Fama-French Three-Factor Model.
While historically significant, the persistence and magnitude of the small cap premium have varied over different time periods and market conditions.
Investors considering exposure to the small cap premium aim to enhance potential risk-adjusted returns within their portfolios.

Formula and Calculation

The small cap premium is not a single, fixed value, but rather an observed difference in returns. It is typically calculated as the difference between the average return of a diversified portfolio of small-cap stocks and the average return of a diversified portfolio of large-cap stocks over a specific period.

\text{Small Cap Premium} = R_{\text{Small Cap Portfolio}} - R_{\text{Large Cap Portfolio}}

Where:

(R_{\text{Small Cap Portfolio}}) = The average return of an index or portfolio representing small-cap stocks (e.g., Russell 2000 Index).
(R_{\text{Large Cap Portfolio}}) = The average return of an index or portfolio representing large-cap stocks (e.g., S&P 500 Index).

This calculation reveals the excess return, if any, that small-cap stocks have provided relative to large-cap stocks.

Interpreting the Small Cap Premium

Interpreting the small cap premium involves understanding its historical context and its implications for asset allocation. A positive small cap premium suggests that investors have historically been compensated for taking on the additional risks associated with smaller companies, such as higher volatility, less analyst coverage, and often greater sensitivity to economic cycles.¹³

When evaluating the small cap premium, it is important to consider the time horizon, as its presence and magnitude can vary significantly over shorter periods. For instance, there have been extended periods where large-cap stocks have outperformed small-cap stocks, leading to discussions about the premium's current viability.¹²,¹¹ However, proponents argue that, over very long investment horizons, the premium tends to reassert itself. The small cap premium, along with other factors, is considered by some to be a systematic source of return in factor investing.

Hypothetical Example

Consider an investor constructing a diversified portfolio. For this example, let's assume the following hypothetical annual returns:

Large-Cap Stock Index (e.g., S&P 500): 8%
Small-Cap Stock Index (e.g., Russell 2000): 10%

To calculate the hypothetical small cap premium for this year:

\text{Small Cap Premium} = 10\% - 8\% = 2\%

In this scenario, the small cap premium is 2%. This indicates that, hypothetically, a portfolio invested in small-cap stocks earned 2 percentage points more than a portfolio invested in large-cap stocks during this particular year. This excess return could influence an investor's decision to increase their exposure to smaller companies, aiming to capture this potential benefit within their portfolio diversification strategy.

Practical Applications

The small cap premium is a critical consideration for investors and financial professionals in several areas:

Portfolio Construction: Investors may intentionally tilt their portfolios towards small-cap stocks to potentially capture this historical premium. This approach often involves allocating a portion of their equity investments to small-cap specific funds or exchange-traded funds (ETFs).
Factor-Based Investing: The small cap premium is one of the foundational factors in multi-factor models used in quantitative investment strategies. These models aim to explain and capture various sources of equity returns beyond just overall market exposure.
Academic Research: The concept continues to be a subject of ongoing academic inquiry, examining its drivers, persistence, and implications across different markets and economic regimes. For instance, research from the Federal Reserve Bank of St. Louis has explored the factors explaining small-cap stock returns.¹⁰
Benchmarking and Performance Attribution: Understanding the small cap premium helps in evaluating investment performance. If a portfolio heavily invested in small caps outperforms, it might be partly attributed to capturing the small cap premium, rather than superior stock picking alone. Conversely, underperformance might be due to a period when the premium was negative. Dimensional Fund Advisors highlights the long-term potential of the small cap premium for investors.⁹

Limitations and Criticisms

Despite its historical observation, the small cap premium is subject to several limitations and criticisms:

Inconsistency and Cyclicality: The premium is not constant and has experienced long periods of dormancy or even negative performance, particularly in recent decades.⁸ For example, large-cap stocks have substantially outperformed small-caps over certain extended periods.⁷,⁶ This inconsistency leads some researchers to question its continued reliability as a persistent factor.⁵
Higher Risk and Volatility: While the premium suggests higher returns, small-cap stocks are generally more volatile and carry higher systematic risk compared to their large-cap counterparts. They may be more sensitive to economic downturns, changes in interest rates, and can exhibit greater price swings.⁴
Liquidity Concerns: Shares of smaller companies often trade less frequently and in lower volumes than large-cap stocks, leading to higher trading costs and difficulty in executing large orders without impacting prices. This reduced liquidity can erode any potential premium.
"Junk" Bias: Some criticisms suggest that the observed small cap premium, especially in earlier periods, might have been driven by very small, low-quality, or distressed companies, which theoretically should command a higher risk premium. When these "junk" elements are excluded, the premium may be less pronounced or disappear entirely. Research Affiliates, for example, has published on whether the small-cap premium is "dead" and whether a "structural premium" truly exists.³,²
Data Snooping: A common academic criticism is that the discovery of the premium might be a result of "data snooping" – finding patterns in historical data that do not genuinely persist in the future.

Small cap premium vs. Value premium

While both the small cap premium and the value premium are distinct factors identified within the Fama-French framework that suggest sources of excess returns, they represent different characteristics of a company. The small cap premium relates to the size of a company, positing that smaller firms tend to outperform larger ones. The value premium, conversely, is linked to a company's valuation, suggesting that "value stocks" (those trading at lower prices relative to their fundamentals, such as book value or earnings) tend to outperform "growth stocks" (those with high valuations and strong growth prospects). Though they can sometimes correlate—for example, smaller companies might also exhibit value characteristics—they are independent factors that can affect returns. Investors often consider both in a multi-factor approach to investing, aiming to capture both size-related and valuation-related outperformance.

FAQs

What is a small-cap company?

A small-cap company is generally defined by its market capitalization, which is the total value of its outstanding shares. While definitions can vary, small-cap companies typically have a market capitalization ranging from $300 million to $2 billion. This ¹is in contrast to mid-cap and large-cap companies, which have higher market capitalizations.

Why might small-cap stocks offer a premium?

Small-cap stocks are often believed to offer a premium for several reasons. They can be riskier and more volatile, less liquid, and have less analyst coverage compared to larger companies, leading investors to demand higher returns as compensation for these added risks. They also often have greater growth potential as they are earlier in their business lifecycle.

Is the small cap premium guaranteed?

No, the small cap premium is not guaranteed. It is a historical observation, and past performance does not indicate future results. There have been extended periods where the small cap premium has been absent or even negative, meaning large-cap stocks outperformed small-cap stocks. Investment in small-cap companies carries inherent risks and can result in losses.

How do investors gain exposure to the small cap premium?

Investors can gain exposure to the small cap premium by investing in dedicated small-cap mutual funds, exchange-traded funds (ETFs) that track small-cap indices like the Russell 2000, or by directly purchasing shares of individual small-cap companies. Such investments form part of a broader portfolio diversification strategy.