Can small-cap stocks boost your returns?

(MoneyWatch) In 1981, Rolf Banz published the paper "The Relationship Between Return and Market Value of Common Stocks." Banz found that small-cap stocks provided higher returns than large-cap stocks. The finding fits nicely with modern portfolio theory -- just as riskier stocks should provide higher expected returns than safer bonds, riskier small-cap stocks should provide higher expected returns than safer large-cap stocks.

However, some have questioned the paper's findings, specifically making three challenges. Let's address those concerns.

Benefited from time period used

We address that issue by looking at the data. We find that in the period from 1927 through 1980, the small-cap premium (the annual average return of small-cap stocks minus the average annual return of large-cap stocks) was 4.1 percent. From 1981 through 2011, there was still a small-cap premium, although it had shrunk to 1.5 percent. It's worth noting that an explanation for the apparent shrinking is that the last few years of the first period (1975-1980) witnessed a bubble in small-cap stocks, similar to the Internet bubble of the late 1990s. From 1975-1980 the small-cap premium was 14.6 percent a year. Thus, we ended the period with very high prices for small stocks -- dooming future returns to lower levels.

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If we change the periods slightly, moving the end date of the first period back from 1980 to 1974 and changing the second period to 1975-2011, we see that the premiums were 2.8 percent and 3.7 percent, respectively -- the premium appears to have increased. Over the full period 1927-2011, the premium was 3.2 percent. It seems hard to conclude that the premium has shrunk.

The premium can't be captured

The second threat to the findings was that because of the higher trading costs of smaller, less liquid stocks, the premium was only a theoretical one. After costs, it couldn't be captured.

The third challenge was that the Banz's data were subject to survivorship bias -- stocks that delisted disappeared from the data, biasing the results upward.

We can address the later two threats by examining the returns of live funds to see if they've been successful at capturing the returns of the asset class of small stocks. We'll begin by looking at the returns of the passively managed Bridgeway Ultra-Small Company Market Fund (BRSIX). We chose this fund because it's passively managed and it invests in the smallest of small-cap stocks -- known as microcap stocks -- where trading costs are likely a great hurdle. The fund's inception date was July 31, 1997.

For the period August 1997 through December 2011, the fund returned 9.1 percent, outperforming the CRSP 9-10 index (the bottom 20 percent of stocks ranked by market capitalization), which returned 8.6 percent. And it came close to matching the 9.6 percent return of the CRSP 10 index (the smallest 10 percent of stocks). Keep in mind that indexes have no costs. It's also worth noting that the Fama-French index of small stocks (which measures returns using academic definitions of asset classes) returned 7.3 percent. At the same time, the Russell 2000 index of small stocks returned 5.5 percent and the Russell 1000 index of large stocks returned 4.1 percent.

As further evidence that a well-structured passively managed fund can capture the returns of the small stock asset class, we can also look at the returns of the DFA Microcap Portfolio (DFSCX) and the DFA Small Cap Portfolio (DFSTX) over the same period. DFSCX returned 7.9 percent and DFSTX returned 7.3 percent. Both funds were able to capture the returns of their asset classes.

It's also worth noting that the Vanguard Small Cap Index Fund (NAESX) returned 6.4 percent. It too appears to have captured the returns of small stocks.

Thus, all four passively managed small-cap stock funds demonstrated that capturing the return of the small stocks is achievable in the real world. The results aren't just theoretical. You should also note that in this period when small-cap stocks outperformed large-cap stocks, the more a fund had exposure to the smallest stocks, the higher was the return, which is exactly the outcome we should expect. We would also expect the reverse to be true in periods when large-cap stocks outperform small-cap stocks.

Because their funds have been in existence for a longer period, we can look at the returns of the two Dimensional Fund Advisors funds for the period beginning April 1992 and ending December 2011. The micro-cap DFSCX returned 11.0 percent and the small-cap DFSTX returned 10.0 percent. The Fama-French index of small-cap stocks returned 10.4 percent, the CRSP 9-10 Index returned 11.3 percent, and the Russell 2000 returned 8.2 percent. Thus, we now have almost 20 years of live data demonstrating that passively managed funds are able to earn the returns of the asset classes in which they're investing.