The 'Small-Cap Effect' Isn't Dead, After All -- Journal Report
By Mark Hulbert
Contrary to reports in recent years that the small-cap effect
has disappeared, it's actually alive and well. We've just been
looking for it in all the wrong places.
The small-cap effect refers to the long-term tendency of
small-capitalization stocks to outperform the large-caps. Since the
mid-1920s, according to data from Dartmouth finance professor
Kenneth French, the 10% of stocks with the smallest market caps
have beaten the largest 10% of stocks by an annualized margin of
2.4 percentage points.
Much of the past two decades have been an exception to this
long-term pattern, however. Over the past 15 years, for example,
the Russell Microcap Index (containing 2,000 of the tiniest
exchange-listed stocks) lagged behind the Russell Top 50 Mega Cap
Index (containing the 50 largest-cap stocks) by 2.5 annualized
According to just-released research, the small-cap effect now
exists almost exclusively within the group of stocks within the
S&P 500. Over the 15 years through 2019, the 10% of stocks in
the S&P 500 that are the smallest have outperformed the largest
10% by 1.2 annualized percentage points. Among stocks that aren't
in the S&P 500, the researchers found, small-caps have slightly
Thank the index funds
The authors of this new research -- Hao Jiang of Michigan State
University, Dimitri Vayanos of the London School of Economics, and
Lu Zheng of the University of California, Irvine -- argue that the
ultimate cause of this change has been the growth of index funds,
and in particular index funds benchmarked to the S&P 500. They
found evidence that this growth has led the average large-cap stock
within the S&P 500 to become overvalued.
That's because any stocks in the S&P 500 that are already
overvalued will become even more so when money flows into S&P
500 index funds. By definition, of course, these overvalued stocks
will have a larger market cap than they would if they were instead
fairly valued or undervalued. Just the opposite will be true for
the group of the smallest stocks. This widening spread in the
valuations of the smallest and largest S&P 500 stocks sets up
the precondition for the former to outperform the latter.
Notice that the professors' argument doesn't rely on an ability
to know which of the stocks in the S&P 500 are over- or
undervalued. Their theory is instead based on the unobjectionable
assumption that overvaluation exists.
The Tesla test
Consider Tesla, which upon joining the S&P 500 in December
became the sixth-largest stock in the entire index, with a market
cap of more than $600 billion. If it was overvalued upon becoming
part of the index, as many believe, then joining the S&P 500
has made its overvaluation even more extreme: The company's market
cap has grown by more than $200 billion in just the few weeks since
becoming part of the S&P 500.
A similar observation can be made of the group of so-called
FANMAG stocks -- Facebook, Apple, Netflix, Microsoft, Amazon.com,
and Google parent Alphabet. These six stocks represent just 1.2% of
the stocks in the S&P 500, but collectively have grown to more
than 20% of the index's total market cap. In part because of the
influx of new money into S&P 500 index funds, their combined
market cap grew by nearly $3 trillion last year. To the extent any
of them was overvalued at the beginning of 2020, they are even more
so today, Prof. Zheng points out. This in turn bodes poorly for
their future performance relative to the smallest 50 stocks in the
S&P 500, whose combined market caps amount to less than 5% of
the FANMAG stocks.
What about the smaller stocks outside of the S&P 500, such
as those in the Russell Microcap Index? Prof. Vayanos says that he
and his co-researchers would expect that the pattern they found for
the S&P 500 to be significantly reduced in smaller-cap indexes,
to the extent it exists at all. There are several reasons for this:
Far less money is benchmarked to those smaller-cap indexes than to
the S&P 500, and smaller-cap index funds are much less
concentrated in their largest stocks. Both are necessary
preconditions for the researchers' pattern to hold.
Prof. Zheng emphasizes that the smallest stocks within the
S&P 500 won't beat the largest stocks all the time. Depending
on the flow of new money into index funds, the largest S&P 500
stocks may very well beat the smallest stocks over the shorter
When that happens, however, the prediction of this new research
is that the situation eventually will reverse.
Mr. Hulbert is a columnist whose Hulbert Ratings tracks
investment newsletters that pay a flat fee to be audited. He can be
reached at email@example.com.
(END) Dow Jones Newswires
January 08, 2021 21:13 ET (02:13 GMT)
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