Do small-cap stocks deliver the goods?

The idea that smaller stocks outperform larger ones over time is widely accepted by investors and academics. The historical evidence for it is solid: while there have been periods when small caps underperformed, over time the "size effect" has shown a respectable premium. For example, between 1995 and 2014, the MSCI World Small Cap index has returned around 9% per year, versus around 8% for the MSCI World index.

As a result, allocating part of your portfolio to small-cap stocks is common advice for investors looking for higher returns. Yet the reality may be more complicated, according to a study by Rob Arnott and Feifei Li, both of investment manager Research Affiliates, and Geoffrey Warren of the Australian National University. In a 2013 research paper called Clairvoyant Discount Rates, they calculated average annualised rates of return for each US-listed stock between 1955 and 2011. Their results suggest that the size effect doesn't work in the way that many investors think it does.

The importance of averages

So what's the explanation? It's all to do with how these average returns combine at the portfolio level. Imagine you invest £1,000 each in two stocks. Over the next ten years, one goes on to return 5% per year and the other goes on to lose 5% per year. The simple arithmetic average of returns from the two stocks is zero. However, investment returns don't combine like that; instead, the compounded gains from the first stock will outweigh some of the losses from the second. After ten years, your holding in the first stock would be worth £1,629 and your holding in the second stock worth £599. That gives a total of £2,228, amounting to an overall return of 1.08% per year higher than the average of the returns on the two stocks.

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Broadly speaking, that's what's going on in the Arnott, Li and Warren study. Their results show that returns from individual small caps were more highly dispersed than those of larger stocks. There were more smaller stocks that made exceptional gains, and more that made big losses. So while the arithmetic average gain from small stocks was lower than for large stocks, very big profits from a small number of winners meant that a portfolio consisting of all the small stocks would have a higher overall return.

Experienced small-cap investors probably won't be surprised by that, since they'll be aware that returns in small-cap portfolios are often skewed towards a handful of big winners. The table below shows our calculations (using Bloomberg data) of annualised total returns for 617 stocks in the FTSE Aim All-Share index and 246 stocks in the FTSE Small Cap index that were listed five years ago. As you can see, there are a small number of stocks with spectacular gains. For Aim, there are also a large number with substantial losses.

The average return from the FTSE Small-Cap stocks was 11.8% per year, versus 12.8% for the index. For the Aim stocks, the average was -3.3% per year, while the FTSE Aim All-Share index returned 3.2% per year. Strictly, we're not comparing like-with-like, since the indices also include returns from stocks that have floated, delisted, or been promoted to the main market or the Mid Cap index during this period. But this gives some idea of the impact of this effect.

Make sure you own outliers

This carries an important lesson for investors in small caps. You need to hold a large number of stocks to stand a good chance of benefiting from the small-cap premium just holding a handful doesn't offer compelling odds. This is especially true when investing in sectors such as IT, biotech and natural resources, which are typical of Aim companies.

It's telling that small-cap growth managers usually run very diversified portfolios: they're well aware that the rate of failures and nasty shocks among their holdings is relatively high. Investors who simply add a few hot growth prospects to their other holdings may do well, but they should be under no illusions about the role of luck. There's a good chance that they could end up with lots of duds, no star performers and some very disappointing returns.

Returns from UK smaller stocks (2009-2014)