The small cap premium is one of the most well-known pillars of factor investing.
The concept is straightforward; investors expect a higher return from smaller companies as compensation for the extra risk they take by investing in those companies. That additional return is known as a premium.
Risk comes in all shapes and sizes; it might be volatility of earnings, a greater chance of smaller companies failing, less liquidity in their shares, or other issues besides.
With all other things being equal in perfectly efficient markets, getting investors to buy into those risks comes at a price.
Not all investors believe markets are this perfectly efficient. Instead they see any performance premium simply as market mispricing, which will disappear over time.
Size isn't everything
Recently the existence of a small cap premium has been challenged. By removing certain periods or groups of stocks from the data set (such as very illiquid micro caps), the premium all but vanished. Over some shorter discrete periods it even reversed.
This is because investment markets are fluid and move in cycles. They evolve over time and that might lead some to question whether a data set used in discoveries several decades past is still relevant today.
While there may be a very long-term premium for investing in small versus large cap stocks, there are nuances behind that relative difference. These might include how in-favour the underlying sectors are, currencies due to domestic and overseas revenues, monetary policy in a region, or even analyst coverage of individual companies. Different elements all feed into the overall performance profile, and they will play out at different times.
In the same way different markets can outperform others over time, different market caps within those markets can do the same. The chart below shows that over the last 5 years the relative performance of UK small caps versus UK large caps has fared better than the same comparison in the US.
Source: Schroders
History repeats
Periods of outperformance will come and go; however, some trends and patterns reoccur.
One is the underperformance of small caps through market shocks where there’s a greater chance of smaller companies failing, leaving them out of favour. And conversely, the outperformance of small caps through a recovery phase where their greater operational leverage and domestic earnings sensitivity gives them strong growth potential.
2020 was a perfect example of this, with UK small caps falling more than large caps through the initial sell off in February/March, but materially outperforming through the recovery phase as can be seen in the graphs below.
A Tactical move
We took advantage of this pattern within our Tactical solution moving overweight to UK small caps to capture the market recovery that unfolded and is widely anticipated to continue.
When we build portfolios, we populate our asset allocation with funds that have exposure to multiple factors, capturing performance through the cycle. With these levers we can make changes to maximise return or manage downside risk within a client’s risk appetite.
Any factor or investment style can go through prolonged periods of relative underperformance – whether that is Value versus Growth, or Large Cap versus Small. Our Tactical solution looks to capitalise on those factors only when the risk/reward opportunity is tilted in the client’s favour.
*Past performance is not an indicator of future returns
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.