Small caps

Market Capitalization
Stocks may be classified by the size of the corporation. This is most commonly done looking at the market capitalization. Market capitalization is simply a measurement found by taking a stock's current share price and multiplying it by the number of stock shares outstanding. Exact market cap ranges will vary among different financial and rating institutions, but there are three different terms commonly used to describe stocks by their general size: Large Cap stocks; Mid Cap stocks; and Small Cap stocks. Market cap terms are relative and are constantly changing as companies get bigger and smaller.

Capitalization ranges for companies that are smaller than small cap stocks include Micro Cap and Nano Cap stocks.

US Markets
Beginning with Rolf Banz in 1981 and continuing with Eugene F. Fama and Kenneth R. French in 1992 and  1999, academic studies have found that US Small Cap and  US Small Cap Value stocks provided premium returns during the twentieth century. These premium returns were accompanied by greater risk. (See Table 3. and Table 4. below). While US Small Cap stocks provided a 2% premium return over US Large Cap stocks over the twentieth century, Small Cap stocks declined a real -70% over three years during the Great Depression and declined a nominal -90.78% (1929 - 1932) and -53.15% (1972-1974).



In addition to a size premium, twentieth century returns showed the presence of a realized value premium. The 1926 - 2000 return of US Small Value Stocks was 14.87% as compared to the 9.92% return of US Small Growth Stocks. Figure 1. shows the growth of a dollar investment in each of the four quadrants of market capitalization from 1927 - 2000. For investors to attain these premium returns required long term holding periods, as the market, value, and size factor returns often rotate over time and there are long periods when portfolio tilts to small and small value stocks lag the market.

The prospective risk premium for Small Cap and Small Value stocks is subject to debate. Reliable future premium returns must be based on compensation for risk, or there is the possibility that, because they are known, they can now be arbitraged. Behavioral economists (see Haugen for a review), have posited behavioral reasons for the historical risk premiums. Others (John Bogle) have expressed doubts as to the viability of the Small Cap and Small Value premium: "From 1925 through 1964 - a period of fully 39 years - small caps and large caps provided identical returns. Then, in just four years, through 1968, the small-cap return more than doubled the large-cap return. Virtually that entire margin was lost during the next five years. By 1973, small caps were about at par with large caps for nearly the full half-century. The small caps' reputation was made largely during the 1973-1983 decade."

Bogle also cites the high transaction costs in executing small cap portfolios as a hurdle for realizing small cap premiums. (See Edelen, et.al. US Large Cap Funds transaction costs (mean 0.77%, median 0.55%); US Small Cap Funds transaction costs (mean 2.85%, median 2.33%)

Vanguard index fund returns
Since 1975, investors have been able to index US Large Cap stocks. Since the early 1990's investors have been able to index US Market, US Small, US Small Value and US Small Growth Stocks. The returns of Vanguard funds are provided in the following three tables. Table 5 shows returns in the 1990's, a period dominated by the returns of Large Cap Growth Stocks; Table 6 shows returns in the 2000's, when Small Cap and Value stocks provided premium returns; and Table 7 provides returns over the entire period. The apparent anomaly of higher period (1990-1999) returns for the Vanguard Small Cap Index Fund over its constituent value and growth index returns is due to Vanguard using, until May 2003, the Russell 2000 Index for the Small Cap fund and S&P style indexes for the Small Value and Small Growth Funds. Since May 2003 all three funds have been indexed to MSCI indexes.

In the three year period since the 2008 downturn (2009-2011}, annualized returns for the Vanguard index funds (investor shares) are as follows:
 * Total Market +15.01%
 * S&P 500 +14.01%
 * Small Cap +19.11%
 * Small Growth +22.20%
 * Small Value +15.96%

International Markets
Research into international stock market performance over the last quarter/half of the twentieth century provided evidence of a realized Small Cap premium. Hawakini and Keim (2000), in a study of 16 international markets found evidence of a small cap premium in 15 of the 16 countries (the exception being Korea, which provided a monthly -0.40% small cap discount). The positive monthly premium ranged from 0.41% in Singapore to 4.16% in Mexico. The data series in the study varied, with most study periods ending in the 1980's to 1990. As Dimson, Marsh, and Staunton report, subsequent to the publication of these findings, the Small Cap premium reversed in international markets during the 1990's.  The 2000's have witnessed premium returns for international small cap stocks as evidenced by the performance of MSCI EAFE indexes:

Small cap international stocks demonstrated lower correlation to US Large (0.72 vs. EAFE 0.86) and US Small (0.71 vs. 0.76 EAFE) stocks during the 1999-2008 period. The case for persistence in lower correlation for small cap international stocks is the tendency for small cap stocks to be economically tied to local national economies as opposed to being global enterprises.

As is true in US markets, international small cap stocks incur higher transaction costs compared to large cap stocks. Quigley provides transaction cost breakdowns for regional markets.

Expected Returns
According to 30 year return estimates from William Bernstein and Rick Ferri small cap stocks can be expected to provide the following returns:

Vanguard Small Cap Funds
Vanguard offers the following Small Cap funds. Note that the Vanguard MSCI based small cap funds, as well as the international small cap fund are also available as ETFS.

Index Funds and ETFs
In addition to Vanguard, Schwab and Dreyfus offer no-load US Small Cap Index Funds. According to IndexUniverse.com, a total of 39 small cap ETFs are currently available. The major ETF managers are included in the table below. One should note that Powershares ETFs are indexed to proprietary quasi-active indexes (the Intellidex and Zacks series).

International Small Cap index funds and ETFs are detailed in International Small-Cap.