As we pointed out in this post , the size factor (in this case we are referring to small companies) is one of the characteristics of companies that usually generates extra profitability in the long term.
Table of Contents
Small Caps bring more profitability
Small companies have somewhat more volatility
Small Caps Provide Higher Risk-Adjusted Returns
“Small Caps” in inbestMe portfolios
Small Caps bring more profitability
In a certain sense, it is an extra consideration that the market gives to the investor for agreeing to invest in smaller companies that are normally considered to be riskier than large companies.
Investors get extra compensation for taking on additional risk.
The size factor tends to be procyclical in nature, outperforming the broader market when times are good and underperforming the broader market in bad times.
The additional long-term performance also comes at the expense of increased volatility in returns.
Also, like the other factors, the size factor can experience prolonged periods of underperformance. For example, over the past few years, US technology mega-caps have outperformed small-caps.
That said, over the long term, it makes sense to assume that the increased risk involved in investing in small-cap stocks will be rewarded with additional returns.
In the following chart we show the performance of the MSCI World Index vs. the performance of the MSCI World Index Small Cap since the beginning of 2001.
Total Return Small Caps
Prepared by the authors with data from Bloomberg
As can be seen in the chart above, the small-cap index (MSCI World Small Cap Index) shows a much higher total return. This is so, despite the fact that in recent years they have gone through a period of underperformance.
Small companies have somewhat more volatility
Small Caps Volatility
Prepared by the authors with data from Bloomberg
The calculations are made in terms of gross returns in $
This higher performance is obtained, as we see in the table above, at the expense of a slightly higher volatility and a higher maximum drawdown (Maximum Drawdown or MD) during the period considered (2001 to 2021).
A curious but positive effect occurs in this case. If we job seekers phone number data compare the MD: we can notice that the MDs of small-cap companies tend to be a bit deeper.
But they also recover more quickly, as they tend to be quicker to react both to downside and upside.
Download guide Learn to invest easily
Max Drawdown in Small Caps
Prepared by the authors with data from Bloomberg
Small Caps Provide Higher Risk-Adjusted Returns
Overall, small-cap companies appear to be a good investment vehicle for investors who are looking at the long term and are not scared off by increased short-term volatility.
One way to measure the efficiency of one asset relative to another is to measure its risk/volatility-corrected return, which is the Sharpe Ratio .
As we can see in the table above, the "Small Caps" obtain a Sharpe ratio (0.51) slightly higher in the period analyzed than the general index (0.48), since the higher profitability more than compensates for its greater volatility.
Although past performance is no guarantee of future results, we have decided to strategically extend exposure to small-cap stocks in our standard indexed portfolios.
We will do this in portfolios with higher risk profiles (7 to 10). Since investors with a higher risk profile usually have a longer time horizon and accept slightly higher volatility, it should not therefore be a big problem for them.
We believe that the higher expected return of smaller-cap stocks outweighs the risk of higher volatility. If anything, it is more efficient in terms of risk/return and fits well into long-term strategic portfolios.
“Small Caps” in inbestMe portfolios
Our interest in introducing “Small Caps” into our portfolios is not new.
These are already present in the inbestMe variable income pension plan with 4% through the Schwab US Small Cap ETF
Our standard dollar ETF portfolios also have indirect exposure to small caps, as they include the CRSP index , which has exposure to small-cap companies.
These portfolios also have exposure to an equal weight ETF that somewhat overweights smaller companies.
Yes, we have decided to add exposure to Small Caps in our standard Euro portfolios, adding 4% in the iShares MSCI World Small Cap UCITS ETF in profiles 7 to 9, and 6% in profile 10. In line with what was discussed above.
In turn, we added 4% in the Vanguard Global Small Cap index fund EUR ACC. In profiles 7 to 9 and 5% in profile 10.
These changes will be made during the months of February and March 2022, taking advantage of the rebalancing of our clients' portfolios, and as always at no additional cost.
