| Some practitioners and academics have long contended that small-capitalization value stocks provide investors with a better return than other market segments.
The recent strong performance of small-cap value indexes has likely regenerated investors' interest in this theory. From 2000 through 2004, the Russell 2000 Value Index generated an average annual gain of 17.2%, compared with an average annual loss of 3.6% for the small-cap growth stocks in the Russell 2000 Growth Index, or an average annual loss of 1.8% for the Russell 1000 Index of large-cap stocks.
As Table 1 indicates, small-cap value stocks did exhibit higher average annual returns than large-cap value stocks, blended portfolios, and growth stocks.
Return To Top
Although the historical returns for small-cap value stocks appear compelling, investors should consider risk, cost, and the likely endurance of a small-cap value premium before making any changes to their portfolio.
"The returns cited represent an unmanaged benchmark of individual stocks," said Don Bennyhoff, an analyst with Vanguard Investment Counseling & Research. "Importantly, they don't reflect the risks investors would face using a style-centric approach or the costs they would incur."
The question of risk
In Table 2, the market segment returns from Table 1 were risk-adjusted using Sharpe ratios, which represent return per unit of risk. The higher the Sharpe ratio, the more an investor is compensated for the risks incurred. The conclusion: Sharpe ratios indicate that small-cap value investors were not exceptionally rewarded for the risks they took. "The small-cap value premium has not been free money," said Yesim Tokat, Ph.D., an analyst with Vanguard Investment Counseling & Research. "Investors have been compensated for the risks they have taken."
Return To Top
In addition, small-cap value stocks do not consistently outperform the other market segments. The standard deviation calculations in Table 2 illustrate that small-cap value stock returns have been more volatile than those for other stock segments. For example, Figure 1 shows that from 1980 to present, there have been five-year periods where small-cap value stocks outperformed the broad stock market by more than 125% and other five-year periods where small-cap stocks underperformed by more than 140%.
Return To Top
"One thing you can count on is that investment styles—small-cap value included—will go in and out of favor," Bennyhoff said. "Prolonged periods of underperformance can challenge an investor's patience and willingness to stay with a style-specific strategy."
Return To Top
Considering costs
Costs are another key issue to consider when evaluating the small-cap value premium. Historical stock data does not consider the cost of execution. Instead, it measures individual stocks, not funds or portfolios. As a result, neither the cost of research nor transactions associated with assembling a portfolio are included. Investors would need to overcome these costs if they wanted to exploit the small-cap value premium. According to Burton Malkiel, author of A Random Walk Down Wall Street, "it may not be possible to exploit the small-firm effect using real money." (Malkiel, 2004)
Return To Top
Endurance
The last issue to ponder is whether the small-cap value premium, if it truly exists, will continue. In an efficient market, is it reasonable to believe that investors would not seek to exploit the small-cap value premium, bidding up prices of these stocks in the process? Some researchers have suggested that if the premium existed, it has since dissipated after the wide circulation of historical small-cap value returns. (Schwert, 2001)
Return To Top
The value of market-weighted portfolios
After considering the evidence, Vanguard maintains that investors should generally hold market-weighted equity portfolios. "Even if the small-cap value premium was actionable, investors would face increased risks and costs by tilting their portfolios away from broad-market weightings," Tokat said.
Return To Top
Notes
- Prices of small-cap stocks often fluctuate more than those of large-company stocks.
- Past performance is not a guarantee of future results.
- Malkiel, Burton G. "Can Predictable Patterns in Market Returns be Exploited Using Real Money?" Journal of Portfolio Management, 30th Anniversary Issue (2004), pp. 131–141.
- Schwert, G. William. "Anomalies and Market Efficiency." In G. Constantinides, Milton Harris, and Rene M. Stulz, eds., Handbook of the Economics of Finance, pp. 937–972. Amsterdam: North-Holland, 2001.
| 
