Reeling In Small-Cap Alpha by Vitali Kalesnik and Noah Beck, Research Affiliates
- Stocks of small companies have higher incidences of price volatility and mispricing, increasing opportunities for investors to earn excess returns.
- Implementing outperforming strategies, such as value or momentum, in the small-cap universe amplifies their alpha-generating potential.
- High trading costs of small-cap stocks disadvantages passive implementation when compared to skilled active management.
Although we live at the edge of the Pacific Ocean, our weekend adventures often take us inland to enjoy the lakes and streams of California and her neighboring states. A favorite pastime is fresh-water fishing. For most, the lure of fishing is a combination of serene beauty, contemplative quiet, and the satisfaction of reeling in as many big fish as possible. We admit that the first two attractions are very appealing in their restorative powers, particularly to office-weary asset managers, but we can’t help being most inspired by the basic challenge of catching a lot of big fish. The folklore claims 10% of fishermen catch 90% of the fish. What do the top 10% know that the others don’t?
Investors’ search for alpha is not dissimilar to the strategies of skilled and experienced fishermen. First, the skilled know the right location. They use multiple lines and hooks or lures to increase their opportunities. And they attract greater numbers of fish by chumming—adding scent or bait to the water. In the world of asset management, we can think of risk and mispricing as the chum that attracts alpha. Just as all fishing locations are not equal—contrast the teeming Lake Tahoe with the perishing Salton Sea—not all segments of the equity market are equal in the opportunities they present for finding alpha.
Small-Cap Alpha: Abundant, but Unreliable
Lake Tahoe is well known for both its abundance and diversity of fish. The academic literature has made a similar case for small stocks, often believed to be a deep pool into which an investor can cast her net and pull out a weighty haul of alpha.
Stocks of small companies vary significantly in price volatility, are more prone to defaults, and have high trading costs. In combination, these characteristics create an unpredictable risk distribution for small-cap stocks, and the same traits contribute to their frequently being mispriced. In addition, many known anomalies, or risk factors, have significantly higher return dispersion among small companies, creating numerous opportunities for alpha production.
Our research shows, however, that small stocks are not a dependable source of standalone premium. Granted, the small-cap universe is plentiful—there are thousands more small companies than large companies—and diverse—the U.S. economy encourages virtually any type of business or strategy an entrepreneur can envision—but these traits alone are insufficient to ensure small caps will unfailingly produce an excess return.
Many market participants believe that, just like value stocks outperform growth stocks, and positive momentum stocks outperform negative momentum stocks, small-cap stocks outperform large-cap stocks. In a recent article (Kalesnik and Beck, 2014), we discuss the evidence that supports the size premium. Table A1 in the Appendix lists the main arguments in favor and against small size as a standalone source of premium. In our view, the arguments against are much stronger than the arguments in favor: we judge the evidence that small-cap companies, in general, outperform large-cap companies to be unreliable. Our advice to the equity investor is to examine that small cap you are considering to be sure it has the alpha-producing qualities you seek—if absent, toss that small fish back, and cast your line again.
Small caps are not the fish, they are the fishing spot—not the source of alpha, but rather a place where alpha can be found.
A Fertile Fishing Spot
Even if small companies are not as a group reliably outperforming large companies, small-cap stocks still hold significant promise for investors—they are a fertile fishing spot for alpha. Small caps, like other investment strategies, benefit from two potential sources of outperformance: 1) exposure to sources of risk that are compensated with higher returns, and 2) systematic sources of mispricing that can be exploited.
Small stocks come with higher risk than large stocks as measured by credit rating, delisting probability, and volatility. Table 1 reports the distress and volatility characteristics of U.S. stocks by size quintile. The S&P credit rating difference between small-cap stocks (B rated) and large-cap stocks (A+ rated) indicates the higher likelihood (over 200 times) of smaller stocks being delisted, often because of default. Small caps have a delisting rate of 2.38% versus 0.01% for large caps.
The higher price volatility of small caps is evident at both portfolio and stock-specific levels. The portfolio composed of the smallest 20% of stocks is about 44% more volatile than the portfolio of the largest 20% of stocks—20.6% versus 14.3%, respectively. A portfolio, however, masks a lot of stock-specific volatility. A comparison of the median stock volatility of the highest and lowest quintiles is significantly more striking: the median volatility of the smallest stocks (50.5%) is almost 100% more volatile than the median volatility of the largest stocks (25.5%). Also, the dispersion in stock volatility is much greater for small stocks than for large stocks, with a 25th–75th percentile range of 32.1%–76.0% compared to 19.8%–33.2%, respectively. With a much wider dispersion in stock-level risk, investors looking to capitalize on known risk premia should consider doing their fishing in the small-cap side of the pond.
Smaller companies, by virtue of their vast numbers, limited market liquidity, and resultant lower investor demand, tend as a category to have very light analyst coverage. Therefore, much less is known by, or available to, the average investor about the fundamental strength of most small companies. Investors struggle to digest this complexity and to translate the information they are able to discern into efficient prices. Greater instances of mispricing are the practical outcome. Such mispricing creates an opportunity for investors to capture excess returns, much as the fisherman’s baited hook entices the next bream that skims by.
If mispricing in the small-cap segment of the market is well known, why does the mispricing persist? Why is it not arbitraged away? One likely reason is high trading costs. Table 2 lists the average bid–ask spreads for each of the size quintiles over the period 1988–2014. The bid–ask spread serves as a proxy for trading costs. Clearly, the average spread is much higher for the smallest-cap quintile compared to the largest over both the entire 27-year period and the last 10 years. Large trading costs make potential trades of small-cap stocks less profitable, allowing the mispricing to persist.
Just as a lake with heavier vegetation provides a more fertile environment for fish to thrive, we believe the small-cap universe provides fertile ground for finding highly mispriced stocks. In the never-ending debate over whether certain sources of outperformance—such as value and momentum—arise from risk or mispricing, for our purposes, it actually doesn’t matter! Based on the evidence we have just presented, small caps offer a bountiful location to find alpha.
Reeling In Alpha
As we stated in the previous section, outperformance requires that risk be adequately compensated by return. In seeking excess returns, we can attempt to exploit the higher riskiness and greater probability of mispricing