The Small-Cap Premium Lives Despite Its Doubters

Larry Swedroe of Buckingham (and director of research with The BAM Alliance) writes on that “investors should be suspicious of claims that they can benefit from well-known information,” making the point by dissecting a recent popular media article claiming that small-cap stocks have underperformed since 1979. Swedroe focuses on an article by Pension Partners LLC that uses the Russell 2000 Index (R2K) as a measure of small-cap performance to make its claims. Swedroe states that “it’s well-known that there are problems with that index . . . and eventually most index funds . . . abandoned the use of that benchmark.” Further, he asserts that the numbers employed in the Pension Partners article are inaccurate – it claimed the R2K returned 10.3% annually since 1979, but Swedroe says the return was actually 11.4% (which makes it just under the S&P 500 for the same period). Beyond that, Swedroe says that “a superior small-cap index is the CRSP (Center for Research in Securities Prices at the University of Chicago) 6-10 Index” and that “simply by using a more appropriate index, the [purported] underperformance of small-caps disappeared and they outperformed.” (The CRSP 6-10 Index returned 13% compared to the S&P 500’s 11.8%).

From there, Swedroe explains the “well-known” reasons for “a small-cap premium,” such as that small companies tend to be more leveraged, have more earnings volatility, and lower levels of profitability. He also highlights a 2002 research article that found that “small and value firms are more susceptible to distress in times of restrictive monetary policy.” His point, however, is primarily that “these relationships have all been well-documented and are well-known” and “if the market already knows the information, it should already be embedded in prices, so it’s unlikely that investors can exploit it.”

The remainder of Swedroe’s article explores “how easy it is to manipulate data to tell the story you want to tell,” relying on work by economics professor Gary Smith. Noting that “‘correlation’ doesn’t mean ‘causation,'” Swedroe says that “in the era of big data, it’s easy to torture the data to uncover some correlation that appears to explain returns.” This, he suggests, may be what is behind the Pension Partners article’s claims. Because “it’s possible to test thousands of relationships until you find the one that ‘works,'” he says, “unless you come up with the theory first, the data may not have any value.” Referencing Smith, he says, “data should be used to find evidence that supports [a] theory, or doesn’t,” but “too many people work in reverse, mining the data and only then coming up with (concocting) a theory to support the data.”