The Illusion of the Small-Cap Premium
Small-cap stocks outperform large-cap stocks, right?
- Small-cap investing is intuitively appealing
- However, small-caps have underperformed in most markets
- Screening out low-quality small-caps has not helped significantly
Investing means parting ways with your money, which is not something we tend to do lightly. The easiest way to get comfortable with an investment opportunity is if great performance is accompanied by a great story. The most popular theme currently is investing in anything AI-related, where story-telling is easy as artificial intelligence will impact our lives. However, if we go back a couple of years, it was the metaverse and blockchain businesses, before that marijuana stocks.
Most themes only last for a short time as company valuations tend to get driven to excessive levels by an enthusiastic investing crowd. At some point, investors realize that the underlying businesses are not able to match the lofty expectations, which leads to a collapse of the stock prices and the entire theme.
Naturally, some themes have more substance and longevity. Private equity firms highlight that investors can harvest an illiquidity premium by investing in their funds. Hedge funds are marketed as offering uncorrelated returns. Private credit funds showcase significantly higher risk-adjusted returns than the S&P 500. And so on (read Private Equity: Fooling Some People All the Time? and Myth Busting: Alts’ Uncorrelated Returns Diversify Portfolios) .
The issue with many of these longer themes is that their fundamentals erode as markets become more efficient, or that new data becomes available that paints a different picture. However, given vested interests of asset managers, the favorable old story keeps on being sold to investors.
In this article, we will explore one of the most popular stories of investing – the small-cap premium.
PERFORMANCE OF SMALL-CAP STOCKS IN THE U.S. STOCK MARKET
First, we evaluate