Avoid small caps – they’ve got no alpha, says top investor


For a generation, academics have argued that you get a premium return by investing in smaller listed companies.

Over recent years, however, belief in this “size effect” has waned, as Family Capital explained last year.

Adding in lags to account for illiquidity takes the historically weak small firm effect and renders it obsolete

Cliff Asness, founder of $143 billion AQR Capital Management, has now gone further and pronounced the size effect dead. In fact, he does not believe it ever existed. 

For sure, he says, you can get periods when small caps outperform. But this relates to the illiquidity of their stock rather than the quality of their earnings.

To put it simply, the supply of stocks issued by small companies is limited compared to large caps. So when demand appears, their share price goes up further.

This means small caps outperform during bull markets, but slump when demand for their stock evaporates. 

They are more sensitive to changes in sentiment. In the parlance, they have a high beta.

In a research paper entitled There Is No Size Effect Asness says: “There is nothing even resembling a long-term simple small firm effect, where the returns of smaller stocks are greater than larger ones by more than implied by their market betas.

“Adding in lags to account for illiquidity takes the historically weak small firm effect and renders it obsolete.”

After comparing today’s data with data used 40 years ago, Asness says investors never realised the importance of illiquidity, and market influences, to small-cap returns.

“Net of using the more accurate databases today versus those used in the original work – and adjustment for underestimated beats  – you don’t find any size effect. Zippo. Nada.” 

And, take it from me, you don’t argue with Cliff Asness, renowned for smashing his computer screen during periods of extreme tension.

Several factors have undermined small-cap beta in recent years. Private investors, for example, used to love them, but they have now switched their attention to funds, ETFs and tech, where mega-stocks rule.

Listed small caps also used to benefit by accessing IPOs on a growth trajectory. These days, however, companies do not rely on the stock market for funding to the same extent. Instead, they tap into the venture capital market, where disclosure requirements are low and founders have the chance to hang onto more of their shares for longer. 

New companies only tend to come to market when they are large, unless they are snapped up by big tech before they have a chance to do so. 

More recently, small companies have been perceived as more vulnerable to Covid-19.  Low interest rates help many small caps stay afloat, but their depressed price weighs down the rest of the market.

Poor sentiment to small caps as a result of these factors means prices have suffered their worst ten-year performance relative to large caps since the Great Depression. 

Over the ten years to May, BlackRock’s Russell small-cap value ETF only rose by a cumulative 110%, against 265% from an S&P 500 equivalent.

To be sure, small caps have outperformed in the UK of late, but this is largely because large British companies are in unfashionable areas like energy, materials and banking.

You still get opportunities to enjoy a good run from a decent small cap when demand for its limited pool of stock suddenly appears. 

With the help of beta, small-cap growth stocks can transform their fortunes more readily by adopting a smart piece of technology, and showing their operations are Covid-19 free. 

But family offices need to know that exceptions prove the rule. Asness argues there is so little quality in the small cap sector that it is remarkable that it has managed to match the market for several periods of time over the last forty years.




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