Small-caps suck. Buy small-caps! – MarketWatch

This is nothing new. The Russell 2000 has done worse than the S&P 500 over the last one year, three years, five years, and 10 years. It fell more than the S&P 500 in 2022—by 20% compared with 18%. But it has risen by less during the boom years. Less upside, more downside. What’s to like?

If you’d invested $10,000 10 years ago in a low-cost index fund that tracks the Russell 2000, such as the widely owned iShares Russell 2000 ETF
IWM,
+0.61%,
fund data company Morningstar says you’d be up to about $19,900, including reinvested dividends (and ignoring taxes). You would have (almost) doubled your money.

The same investment in a low-cost S&P 500 large cap ETF, such as the State Street SPDR S&P 500 Trust
SPY,
+0.96%
? You’d have $29,600. You’d have nearly tripled your stake—or, to put it another way, you’d have made twice the return.

If that’s not bad enough, consider this. Doug Ramsey, chief investment officer at Leuthold Group in Minneapolis, provides us with the chart at the top of this article. It shows the comparative returns of the Russell 2000 versus the S&P 500 going back more than 40 years, to when Jimmy Carter was president.

And small-caps have pretty much sucked. Since the early 1980s they have, overall, been a much worse investment than large-company stocks, although there have been periods when they have done well.

Many fund managers still talk about the “small cap effect,” the idea that “small-caps outperform large-caps over time.” But that was an idea popularized in the early 1980s—when small-caps were riding high. It was in the early 1990s when economists Eugene Fama and Kenneth French first argued small-caps tend to outperform in their seminal work on the so-called “three factor model.”

(This has now been expanded to a “five factor model.”)

In 2018 financial economists Ron Alquist, Ronen Israel and Tobias Moskowitz calculated that there was no such thing as a small-cap effect, and might never have been. Small-caps, they argued, had not outperformed large-caps over the long term. “Using 90+ years of U.S. data, there is no evidence of a pure size effect, and moreover, it may not have existed in the first place, if not for data errors and insufficient adjustments for risk and liquidity,” they wrote.

Ouch.

So, small-caps aren’t a good investment—right?

Well, not so fast.

Actually, there are some solid reasons why they might be—especially now.

The first thing to note is that the idea that small-caps are doomed to underperform large-caps makes no logical sense. They are certainly riskier: Many are young companies that will never succeed. And others, even those on a solid financial footing, will inevitably face a higher cost of capital, and run more business and financial risks. If small-caps overall aren’t correspondingly cheaper, no rational person would buy them.

And while the market is certainly irrational in the short term, in the long run, as Warren Buffett likes to say, it is a weighing machine, not a voting machine.

****So, logically, small-caps ought to be a good investment—at least, most of the time, and in a reasonably rational market.

The second thing to note is that this dismal small-cap performance is based on the very broad Russell 2000 index. But that index casts a wide net, and includes a lot of especially risky companies. A narrower index, the S&P 600 small cap index
SML,
+0.88%,
is much more discerning: Companies need to pass slightly higher financial hurdles to be included. And the S&P 600 has proved a better investment. For example, iShares Core S&P Small Cap ETF
IJR,
+0.91%,
which tracks the S&P 600, has outperformed the iShares Russell 2000 ETF over 3, 5 and 10 years. That same $10,000 stake 10 years ago, which would have ended up as $19,980 in the IWM, would have ended up as $22,930 in the IJR. Far short of the S&P 500, of course, but well ahead of the Russell-based fund.

Data from FactSet show that since the S&P 600 small cap index was launched in 1994 it has actually beaten the S&P 500, by a small margin, overall. And the S&P 600 has never in all that time had a losing five-year period, when nominal returns (before inflation) were negative. The S&P 500 has had five.

And there may be a very simple reason for this. In a research paper published in 2015, and whose authors included two of those who were skeptical of the overall “small-cap effect” in the paper mentioned above, analysts found that higher quality small-caps had trounced lower quality companies by a wide margin over the long term. The small-cap effect, if it exists, is most pronounced among better quality small-caps—those with better cash flow, balance sheets, stability and so on. The paper, humorously, was entitled “Size Matters, If You Control Your Junk.” The lead author was Cliff Asness, the highly regarded founder of hedge fund firm AQR.

The next argument for small-caps is to remember that Wall Street is more of a slave to fashion than any teenager you have ever met. The street of shame is absolutely obsessed with the latest thing, and wouldn’t be seen dead owning last year’s hot stocks. This is so hilariously predictable that there is money to be made just selling what’s hot and buying what’s not. Buffett (again), citing his guru Benjamin Graham, has compared “Mr. Market” to a manic depressive business partner. One day he is full of despair and wants you to buy him out at almost any price. The next day he is euphoric and will offer you the moon for your stake.

The dismal recent performance of small-cap stocks is a good argument for buying them, not selling them. Indeed by Ramsey’s chart we are pretty much back where we were around 2000, when small-company stocks were cheap and large ones were expensive. Over the next decade you wanted to own small stocks, not big ones.

The most rational approach for a long-term investor who wants to win may be to split the difference. Put half your U.S. stock market exposure in the S&P 500 and half in small-caps—using the better quality S&P 600, rather than the Russell 2000. And rebalance once a year, so that you sell down whatever has done better, and buy more of whatever has done worse, so you bring it back to 50/50. This strategy would have served you well over the past three decades, and may well do again.