The Size Factor: A Case Against Small Caps

Although investors expect to be compensated for the higher inherent risk associated with small cap stocks, historical returns haven’t supported this thesis, according to an article in CFA Institute that analyzes whether different size metrics might have generated better performance.

“Market capitalization is the prevailing metric for weighting stocks in equity indices. But it’s not the only way to measure the size of companies,” the article argues, outlining four alternative metrics that CFA Institute applied to the U.S. stock market going back to the year 2000:

  • Average Daily Value Traded (ADV)
  • Total Sales
  • Enterprise Value
  • Total Assets

The article explains that the results showed varied performance based on the size–market cap and ADV generated almost identical returns, while enterprise value (which includes market cap and debt) resulted in flat performance, and those companies weighted according to asset base and sales generated negative returns.

While the article notes that the “lack of a US small-cap premium is perplexing,” it suggests that this may be a phenomenon unique to the US market. “The same strategies applied in European stock markets, it turns out, yield positive and relatively consistent returns since 2000.”

Although investors often combine factors and research shows that including the Size factor “in a multi-factor portfolio boosts performance,” the article concludes that “the long-term data for the US stock market contradicts this strategy’s underlying thesis—that the greater risk yields greater returns.”

“Unfortunately for aspiring small-cap investors, the message is clear: Alternative Size factor metrics do not boost performance.”