Article Proving Small-Cap Advantage Wrong Misses the Mark

The recent cover story of Financial Advisor magazine took on the topic of small-cap stocks versus large-cap stocks. Specifically, the authors argued that "large beats small," supporting this argument by showing that large caps have had higher risk-adjusted returns than small caps since 1982. My Buckingham Asset Management colleague Kevin Grogan and I found several problems with the article.

Incorrect Argument First, the argument for investing in small caps is that they've provided higher returns for the extra risk, not that they provide higher risk-adjusted returns. Small-cap stocks are riskier than large-cap stocks and should be priced to provide higher expected returns.

Misinterpreted Study Second, the authors say that professors Eugene Fama and Kenneth French were attempting to determine in their paper "The Cross-Section of Expected Stock Returns" whether investors were adequately compensated for the additional risk of small caps. At this point we were wondering if the authors even read the paper. The paper never discusses this issue.

Capturing Returns Third, the authors said they determined whether the DFA US Micro Cap Portfolio (DFSCX) fund successfully capitalized on the idea that small beats large. DFA never attempted to capitalize on the idea that small beats large. It simply wanted to deliver the return of the micro-cap asset class. From January 1982 thru July 2011, DFSCX returned 11.9 percent per year, while the CRSP 9-10 Index returned 11.3 percent per year. I would say DFA has been successful in delivering the asset class return.

Results and Conclusions Don't Match Fourth, the statistical results shown don't match the conclusions drawn. The article authors say that because large-cap stocks have had higher returns over certain time periods, large-cap stocks have an advantage over small-cap stocks. (Note that over the full time period, 1926-2010, the Sharpe ratios are almost identical. The CRSP 9-10 had a Sharpe ratio of 0.112, while the S&P 500 had a Sharpe ratio of 0.113.)

For a variety of reasons, including liquidity risks, small caps are riskier investments than are large caps. Their higher return is not a free lunch, instead it is compensation for the extra risk. Thus we must expect that the risks can show up, even over very long periods. To demonstrate the point, let's apply the authors logic to compare the S&P 500 Index to long-term government bonds from 1968-2008, The Sharpe ratio of the S&P 500 over this time period was 0.078, while the Sharpe ratio of long-term government bonds was 0.089. Using the same logic as the authors, long-term government bonds have an advantage over large-cap stocks, and all of the research showing the advantage of stocks is flawed. This is obviously data mining on my part, but I use an extreme example to prove my point.

Evidence From Other Markets Fifth, if the authors are correct in their analysis, we should see the same results internationally. From 1970-2010, the Sharpe ratio for the Dimensional International Small Cap Index was 0.165, while the Sharpe ratio for the MSCI EAFE Index was 0.086. If we start in 1982 (like the authors did in the article), the Sharpe ratio for the Dimensional International Small Cap Index was 0.138, while the Sharpe ratio for the MSCI EAFE was 0.100. What about emerging markets? From 1989-2010, the Fama-French Emerging Markets Small Cap Index had a Sharpe ratio of 0.157, while the MSCI Emerging Markets Index had a Sharpe ratio of 0.107. The results don't seem to hold up out of sample.

The bottom line is that the article in Financial Advisor magazine is a classic example of the straw man fallacy. The article attempts to counter the argument that small-cap stocks have higher risk-adjusted returns than large-caps, when the argument all along has been that the higher returns of small caps are simply reward for higher risk.

Photo courtesy of RobinEllisActor on Flickr.
More on MoneyWatch:
9 Bits of Conventional Wisdom You Should Ignore International Investing Myths You Shouldn't Believe How to Properly Name IRA Beneficiaries Passive Management Wins in Emerging Markets International Diversification Still Works, if You're Patient
Three ways I can help you become a wiser investor:

• Follow me on Twitter: http://twitter.com/larryswedroe.
• Read my latest book The Quest for Alpha.
• Download the podcast of my radio show via Buckingham Asset Management's iTunes page.