The Problem With Small Cap Stocks

TL;DR

Small cap stocks have historically outperformed large cap stocks, but recent research shows that there is no evidence to support the existence of the size effect. Investors should carefully consider owning small cap ETFs.

Transcript

• You probably won't be surprised if I tell you that small cap stocks in general have outperformed large cap stocks over the longterm, even on a risk adjusted basis with risk measured as standard deviation. This is a well-documented around the world and over time. Small caps were the first market anomaly that challenged the capital asset pricing mo... Read More

Key Insights

• 👲 Small cap stocks have historically outperformed large cap stocks, challenging traditional asset pricing models.
• 👨‍🔬 Recent research has shown that the size effect may not exist and is not statistically significant.
• 🛩️ Implementation of small cap ETFs is challenging due to the concentration of the size effect in the smallest stocks and higher fees associated with small cap index funds.
• 👲 Small cap growth stocks with low profitability drag down the performance of the entire small cap asset class.
• 😘 Removing small cap growth low profitability stocks from the data reestablishes the size premium.
• ✋ Access to higher quality small cap funds, such as those offered by DFA, may be limited for DIY investors.

Questions & Answers

Q: Why have small cap stocks historically outperformed large cap stocks?

Small cap stocks have historically outperformed large cap stocks due to the size effect, which challenged the capital asset pricing model and led to the development of multi-factor asset pricing models.

Q: Is there evidence to support the existence of the size effect?

Recent research has shown that there is no statistically significant evidence to support the existence of the size effect. The size premium is not consistently observed and may not exist.

Q: What are the implementation challenges of small cap ETFs?

Small cap ETFs face challenges in implementation due to the concentration of the size effect in the smallest stocks, which are expensive to trade. Additionally, small cap index funds generally have higher fees compared to other index funds.

Q: Are there any small cap ETFs that effectively capture the size effect?

Finding small cap ETFs that effectively capture the size effect is difficult, especially for DIY investors. Even relatively decent small cap ETFs may not make the necessary correction for small cap growth low profitability stocks.

Summary & Key Takeaways

• Small cap stocks have historically performed better than large cap stocks, challenging the capital asset pricing model and resulting in multi-factor asset pricing models.

• Recent research has shown that the size effect, which led to the outperformance of small cap stocks, is not statistically significant and may not exist.

• Implementation of small cap ETFs is challenging due to the concentration of the size effect in the smallest stocks and the higher fees associated with small cap index funds.