Securing Alpha From Small-Cap Stocks

 

Vitali Kalesnik and Noah Beck of Research Affiliates provide a detailed analysis of how investors may be able to capture alpha in the small-cap sector.  They liken investing in small-caps to fishing in a pond where alpha is available, but the fisherman’s strategy and skill determines whether one can “reel it in.” They suggest that “small size as a standalone source of premium” is not reliable, but contend that “[e]ven if small companies are not as a group reliably outperforming large companies, small-cap stocks still hold significant promise for investors.”

They point to “two potential sources of outperformance: 1) exposure to sources of risk that are compensated with higher returns, and 2) systemic sources of mispricing that can be exploited.” They examine small-cap investing according to value, momentum, and quality strategies, noting that “[b]ecause small-cap stocks have high trading costs, implementation skill matters—a lot.” Thus, “[p]assive implementation of investment strategies in the small-cap segment of the market is definitely disadvantaged versus their skilled active implementation.” Ultimately, then, the report suggests that small-caps offer fertile ground for investors, and that reaping outperformance may depend on using multiple strategies and having the skill to bring down trading costs.