Small-cap premium?

Academic research in the U.S. has shown that in addition to market risk, certain dimensions of the stock market or “factors,” including company size, explain stock returns. Over long periods of time, small-capitalization stocks, on average, have higher returns than the stocks of large companies and, hence, exhibit a size premium.

From January 1926 through September 2014, small-cap stocks in the U.S. outperformed large-cap stocks by an annualized 2% a year, as measured by Ibbotson Associates Inc. More recently, with the collapse of the tech bubble in June 1999 through to September 2014, the annualized return premium of small-cap stocks over their large-cap brethren soared to 6.4% per annum.

In contrast, over the same period in Canada, the 5.5% annualized return of small-cap stocks, as measured by the S&P/TSX small-cap index, lagged both the 7.7% of the broad Canadian equities market (represented by S&P/TSX composite index) and the 7.6% return of large-cap stocks (S&P/TSX 60 index). To add insult to injury, the lower return of small-cap stocks was accompanied by much higher volatility and deeper drawdowns.

Longer-term data also display a pattern of underperformance. Cliff Asness, Andrea Frazzini and Lasse Pedersen, principals with Greenwich, Conn.-based AQR Capital Management LLC have compiled a data set of global factors that includes small- vs large-cap stock performance in Canada. From July 1983 to September 2014, Canadian small-cap stocks lagged large-cap stocks by 1.5% a year on average. In contrast, over this same time frame, small-cap stocks in the U.S. outpaced large-cap stocks by 0.4% a year.

As factor returns are highly time-dependent, the above study does not mean the small-cap premium does not exist in Canada. Academic studies completed in the late 1990s and early 2000s that incorporated return data from as far back as 1960 found evidence that small-cap stocks in Canada, on average, outperformed large-cap stocks.

What AQR’s more recent data suggest is that such outperformance is sporadic and that extraordinarily lengthy periods of time can elapse before the small-cap premium manifests itself. As the materials and energy sectors constitute a much higher proportion of Canadian small-cap companies vs large-caps, commodities cycles probably play a major role in the timing of the small-cap premium. Also, the speculative excesses at the peaks of these sectors’ cycles might adversely affect the small-cap premium.

The message for financial advisors and their clients is multi-fold. Portfolios that are excessively weighted in Canadian small-cap stocks may underperform for such a lengthy period that clients will abandon the strategy long before any premium appears. Hence, judicious allocations are critical.

Second, advisors pursuing the small-cap premium should diversify among small-cap stocks globally because the premium may appear at different times in different countries.

Finally, advisors need to consider how they will pursue the small-cap premium. A multi-factor approach that incorporates dimensions of value and quality in addition to size could provide more consistent results.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own securities mentioned in this article.