Smaller companies: big opportunity?


Why should investors in smaller companies expect a higher return? What are the risks involved? And what are the opportunities for active managers?

In this piece, we set out the historic strong performance of smaller companies. We describe the fundamental drivers of their above-market returns and the risks involved. We explain the different risk exposures that create the opportunity to add value through portfolio diversification. And we highlight the opportunity for active management.

For investors looking for a deeper understanding, we explore the history of poor performance of junior stock markets and the opportunities that arise as they mature. We dig deeper into the differences between large and small-cap exposures. These include higher credit costs, different country and sector exposures, and lower average levels of profitability. And we review academic studies of smaller companies, finding anomalies that active investors can aim to exploit. We finish with a brief history of smaller-company investing.


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Chapter 1

Above-market returns from a broad and deep investment universe

Why should investors consider allocating money to smaller companies? Why should they expect a higher return? And what are the risks involved?

The Center for Research in Securities Prices at the University of Chicago Booth School of Business provides the longest history of size-ranked stock indices. A dollar invested in US larger companies in 1926, with dividends reinvested, grew in value to $5,767 by the end of 2017. A similar investment in small-caps grew to $38,842, over six times more.1 A 2% annual return premium translates into a significant sum when compounded over a number of decades.

“Smaller companies represent a greater proportion of the world index than any single country outside the US.”

Chart 1: Cumulative historical performance of US small-caps and large caps, 1926-2017

Chart 1: Cumulative performance of US small-caps and large caps, 1926-2017 Source: Professors Dimson, Marsh, Staunton and Evans, London Business School, CRSP, Morningstar, December 31,2017

Smaller companies raced ahead between 1975 and 1983, attracting the attention of academics and investors. Between 1984 and 1997, the ‘small-cap premium’ turned negative, leading investors to question the higher return produced by investing in smaller companies over large. Instead this difference was rebranded the ‘small-cap effect’, reflecting that smaller companies performed than large, sometimes lagging and sometimes leading.

The poor performance during the 1980s and ‘90s was not just the unwinding of a crowded trade. The composition of small-cap indices was changing. The globalization of manufacturing was transforming the investment landscape. Industrial production was shifting from the developed world to the emerging world. Small-cap indices started to fill up with fading manufacturing companies.

Similarly, the recovery since the turn of the century has occurred against the backdrop of improving fundamentals. Small-cap indices have benefited from the strong performance of companies that have captured the growing opportunities created by technological advances.

Small companies – big investment universe

Smaller companies represent a greater proportion of the world index than any single country outside the US. They also represent a higher weight than the combined emerging markets. They account for 13% of the MSCI All Country (AC) World IMI Index.2 This index captures 99% of the global equity investment opportunities, across 23 developed markets and 24 emerging markets, including large and small-cap stocks.

They are also large in number. Splitting this index by company size, the MSCI AC World Small Cap Index has 5,967 constituents. By comparison, the MSCI AC World index (of large and mid-cap stocks) has 2,758 constituents.

Chart 2: MSCI All Country World IMI Index, by market capitalization

Source: MSCI, December 31, 2018

Chart 3: MSCI All Country World IMI Index, by number of index constituents

Source: MSCI, December 31, 2018

Smaller companies premium – a global perspective

Rolf Banz, a PhD student at the University of Chicago, first identified the small-cap premium in US stocks in 1981.3 This triggered similar studies around the world. In a 2018 study, Professors Dimson, Marsh and Evans from the London Business School provided a global perspective.4 They calculated the small-cap premium to be 5% annually for the largest 28 countries in the FTSE World Index between 2000 and 2017. Smaller companies outperformed in 25 of the 28 countries (see chart 4).

Chart 4: Global smaller companies premiums from 2000 to 2018

Source: Professors Scott Evans, Paul Marsh and Elroy Dimson, Numis Smaller Companies Index 2019 Annual Review, December 31, 2018

Smaller companies effect – understanding the risks

The fundamental explanation for the small-cap premium is that the stocks of smaller companies are higher risk. Returns are higher but so is the volatility of returns. There is no ‘free lunch’ available simply by buying a smaller companies index. Instead, successful investing requires a deep understanding of these risks and the potential rewards that they offer.

“Smaller companies represent a greater proportion of the world index than any single country outside the US.”
Small-cap premium:

the outperformance of smaller companies over large

Small-cap effect:

the tendency of smaller companies to perform differently from large


The maturing of junior stock markets

The success of NASDAQ, the US stock exchange ‘junior’ to the mainstream New York Stock Exchange, has led to many imitators. More than 130 new junior stock exchanges in more than 70 countries had formed by 2015. Lower barriers to entry led to high failure rates among the listed firms. However, these markets are maturing. Investors who look at individual companies rather than buy an index are able to find attractive opportunities.


the risks

Chapter 2

Explaining the return premium and exploring the diversification potential

What are the higher risks that explain the small-cap premium? And what characteristics explain why smaller companies perform differently than their larger peers?

Risk and return are two sides of the same coin. Academic studies have tried to identify the higher risks involved in investing in smaller companies. These help explain why investors should demand a higher return. Less noticed are the risks that are lower for smaller companies than larger. Investors also need to understand the risks that are neither greater nor smaller but simply different. These provide a source of diversification. Finally, investors cannot ignore the risk factors that are common to all companies, large and small.

“Academic studies have tried to identify the higher risks involved in investing in smaller companies. These help explain why investors should demand a higher return.”

A smaller company can have a lower market value for two reasons:

• it is small (which investors can measure in a number of ways), or

• it is relatively risky.

Investors should apply a higher discount rate to future cash flows of more risky companies. A higher discount rate means a lower valuation. In other words, for two companies with the same annual sales, the riskier company will have the smaller market capitalization.

Does Size Really Matter? by Professor Jonathan Berk looked at the performance of smaller companies, classified by factors other than market capitalization, such as annual sales.8 Using these other measures, he found that returns were unrelated to size. The relative riskiness of smaller companies is the dominant factor in explaining the observed relationship between market value and returns. Understanding these risks is key to understanding the value of the company.

In general, academics explain the small-cap premium as the reward for accepting the poor performance of smaller companies during periods of market stress. Active investors must decide if they are being adequately rewarded for this risk. Or they can decide to control these risks, for example by tilting portfolios toward higher-quality companies.

In summary, an investment in a smaller-companies index is higher risk than the equivalent larger-companies index. But investing in a smaller-companies portfolio does not have to be.

Higher risk

1. Illiquidity risk

The shares of smaller companies are less liquid. They also have higher insider ownership, leaving a smaller free-float for external shareholders. This risk can be mitigated in a portfolio context. However, it translates into a higher cost for entering and exiting positions.

2. Recession risk

Smaller companies have historically underperformed from the peak of an economic cycle to its trough (see chart 6). For the US equity market, this underperformance was 5% on average during the five recessions that have occurred since 1980.9 A longer view captures the Great Depression (1929-1933) and the deep recession of the 1970s (1973-1975).1 These were periods of significant pain for holders of smaller companies.

Chart 6: US Small-cap relative performance and US recessions, 1926 - 2017

SO: Chapter 2 - Chart 6: US Small-cap relative performance and US recessions, 1926 - 2017 Shaded areas indicate US recession.
Source: Professors Dimson, Marsh, Staunton and Evans, London Business School, CRSP, Morningstar, NBER, December 31, 2017

This analysis is based on perfect hindsight of when recessions began and ended. In practice, there is a long lag between the start of a recession and its identification. We associate recessions with bear markets. But here too, investors require hindsight to identify the start of a bear market. Nor do economic downturns and market downturns neatly coincide. This helps explain the somewhat counterintuitive findings of a Numis study.4 UK smaller companies outperformed in bear markets, but underperformed in recoveries (see chart 7).

Chart 7: When do small caps do well?

Source: Scott Evans and Paul Marsh, Numis, December 31, 2017

3. Credit risk

The cost of borrowing is higher for smaller companies.10 (Indeed the cost of equity is higher too. Lower average valuations for share buyers translate into higher cost for the companies issuing those shares.) This is consistent with the underperformance of smaller company shares when times are tough: during recessions. The small-cap premium is higher when rates are low than when they are high. And higher when interest rates are falling than when they are rising.

4. Inflation risk

Equity market valuations are higher when inflation is close to target. They are lower in periods when inflation is high, or when inflation falls close to zero or turns negative (deflation). This pattern is exaggerated for smaller companies. This means the small-cap premium is higher when inflation is close to target but lower during periods of low or high inflation.4

5. Price volatility

The risks above translate into higher volatility of returns for an index of smaller companies than their larger peers.

Lower risk

6. Complexity

Big companies are complex organizations. Sony grew rapidly in the second half of the 20th century on the back of sales of Trinitron TVs and the Walkman. By the 1990s, the company had become a bloated behemoth, employing 160,000 people.11 With profits under pressure, the company divided into smaller units, asking each to focus on their own profitability. In 1999, one unit launched the company’s first portable digital player at a trade fair in Las Vegas. Next on stage was a rival product from a competing Sony unit. Not surprisingly, consumers were confused and both failed. The complexity of large companies makes it harder for management to be in control.

7. Index concentration

The composition of market indices reflects past success. Sometimes one theme dominates the market, leading to a concentration of stocks at the top of the list. Today, five US technology companies head the MSCI World Index: Apple, Microsoft, Alphabet (which owns Google), Amazon and Facebook. Together they represent a combined 7.5% of the index.12 This concentration increases in regional portfolios and is yet more pronounced in single country portfolios. For example, Samsung Electronics represents 28% of the MSCI Korea Index.13 A few large stocks can skew the overall performance of market-cap weighted equity portfolios.

Different risks

8. Currency exposure

Smaller companies have a higher proportion of domestic sales, while larger companies include more multinationals. For example, domestic sales account for 63% of total sales for companies in the MSCI US Index. This compares to 78% of sales for companies in the MSCI US Smaller Companies Index.14 This means small and large companies have different responses to currency moves.

9. Stock-specific risk

Stock-specific risks are a more significant driver of performance for smaller companies than their larger peers (see chart 8). By contrast, larger companies are more sensitive to other factors such as country, sector and style.

Chart 8: Stock specific risk as percentage of total risk

Source: Axioma, December 31, 2018

10. Different companies

A portfolio of smaller companies is a different set of companies to a portfolio of larger companies. This might seem too banal to mention. Yet investment in factor-driven (or smart-beta) portfolios is growing and can lead to the same stocks appearing in more than one factor sub-portfolio. For example, 55 of the 151 companies in the iShares Edge MSCI USA Value Factor ETF are also included in the iShares Edge MSCI USA Size Factor ETF15. This overlap is illustrated in the Venn diagrams below (see chart 8).

Chart 8: Index overlap: number of stocks

“Academic studies have tried to identify the higher risks involved in investing in smaller companies. These help explain why investors should demand a higher return.”
Source: MSCI, ISHARES, December 31, 2018

11. Long-cycle performance

These different risks help explain why capturing the small-cap premium involves periods of outperformance and underperformance. The cycle between small-cap and large-cap leadership differs across different countries. These cycles can last for a number of years.

Same risks

12. Traditional risk measures

Portfolio managers still need to account for country, sector and industry exposures. They need to understand their exposure to style factors, such as quality, momentum and value. And, in particular, they need to be aware of the stock-specific risks. These are best understood through fundamental analysis.

In conclusion, investors must understand the complex set of risks associated with smaller companies. But it is this understanding that provides the opportunity for active managers to deliver performance.

Beyond size - digging deeper into the differences

How does a portfolio of smaller companies differ from a portfolio of larger companies? We provide facts and figures to illustrate the differences. We look at borrowing costs, company fundamentals, country and industry weights, analyst coverage and regional performance differences.


The opportunity for
active management

Chapter 3

Adding value through fundamental analysis in a large, under-researched universe

Where are the opportunities for active managers to add value when investing in smaller companies? And how does this differ from their peers investing in larger companies?

Larger universe + fewer analysts = greater opportunity for active managers

There are fewer investment banking analysts per company for small companies than large. This is due to the combination of a larger number of companies and their lower market capitalization. Lower capitalization means lower share turnover, which translates into lower revenue for the investment bankers. The US market represents nearly half of the MSCI AC World Smaller Companies Index. Here there are 23 analysts covering large-cap companies on average compared to seven for small-caps.16

MIFID II regulations are reshaping the broking industry. One year after the new regulations took effect, a Numis study of the UK smaller-companies market looked at the effect on analyst coverage.17 They found that total research coverage had declined by about 8%.

"The dominant risk – and opportunity – in a smaller companies portfolio is stock-specific risk"

An earlier Numis study found that broker recommendations on small-cap stocks added value.4 Relative returns were positive when there had been a strong consensus buy. (There was one exception: stocks with just one recommendation). By contrast, this was not the case for large-cap stocks.

The stocks of smaller companies also have a wider range of investment outcomes, from best to worst performer. Of the stocks in the MSCI AC World Smaller Companies Index, 26% generated positive returns of over 50% in 2017. This compares to 17% for the MSCI AC World Index.18 Just 0.5% of the Smaller Companies Index (70 stocks) saw negative returns of greater than 50%, compared to 0.02% (or just five stocks) of large and mid-cap stocks. This reflects a wider range of fundamental outcomes. Smaller companies have more scope to grow. But they also include a higher proportion of loss-makers: 16% for the MSCI AC World Smaller Companies Index versus 7% for MSCI AC World Index in 2017.

The small-cap research that is available is often much shallower. This information gap opens up opportunities to find compelling investment ideas that others have yet to discover.

Rising role of passive investors

Three trends are combining to leave an increasing portion of the equity market under the management of passive or quantitative investors.

First, the shift in assets from active to passive management has been a pervasive theme among large-cap portfolios. However, it is less significant for smaller companies, although it is growing from a low base. The fee differential between passive and actively managed equity funds is less stark for smaller companies. Fidelity recently made headline news by offering two zero-fee funds to US investors. A UK investor in Vanguard’s FTSE 100 Index Unit Trust will pay ongoing charges of just 0.06%.19 By contrast, the Vanguard Global Small-Cap Index Fund has ongoing charges of 0.38% for UK investors.

Second, smart-beta products are growing in popularity, with investment decisions driven by quantitative models. Assets under management for these products, in mutual funds and ETFs, surpassed $1 trillion in 2017 according to Morningstar. Many products include a tilt to smaller companies (or size factor, alongside value, quality, momentum and low volatility strategies).

The cost of gathering and processing data has fallen. The number of investment professionals with quantitative skills has risen. These quants can rapidly turn the latest academic research into investment practice. However, anomalies that can be exploited by fundamental analysis persist among smaller companies. This is, in part, due to higher trading costs and limited scope to implement short positions.

Third, there has been a growing role for macro managers. They typically buy and sell index products to implement their trading views. They often ignore smaller companies altogether. If they do invest in smaller companies – long or short – it is typically to take a view on the relative merits of smaller companies versus large.

Together, these trends mean managers who do not analyze individual companies play a growing role in the market. This may increase the scope for stock-pickers to add value through fundamental analysis.

Institutional investors often overlook smaller companies

Few institutional investors break out smaller companies from the wider equity category.

The author (Harry Nimmo) has a strong track record of investing in smaller companies – one that stretches over more than two decades. Yet Requests for Proposals (RFPs) have been extremely rare. Many institutional investors follow the advice of investment consultants. Consultants help their clients design and validate their long-term investment strategy. This important and influential group of advisors has systematically over looked the opportunities within the large investment universe of smaller companies.

A style analysis of a typical actively managed equity portfolio would show an overweight to smaller companies. A typical fund is underweight the very largest companies in an index. And, when permitted, these funds own a handful of (the largest) smaller companies. This factor exposure discouraged adding a dedicated exposure to smaller companies.

Investors who ignore smaller companies based on style analysis overlook the stock-picking opportunities within a very large portion of the overall equity market.

Wide range of risks = wide range of opportunities

The small-cap universe is large, placing a premium on manager resources. Extracting value from a large universe of global stocks requires a disciplined investment process. Some form of quantitative screening is a necessary first step in assessing over 6,000 companies. This is true whether investors base their subsequent decisions on judgement, quantitative analysis or a combination of the two.

The small-cap premium is not the only style premium available to investors in smaller companies. Value, quality, momentum and low-volatility strategies have also delivered long-term premiums, but also with significant periods of underperformance. For example, value has lagged even on a decade-long view.

Investors also need to be aware of country, industry and currency risks. This is true whether they actively target these risks or they are a by-product of their stock selection process.

Company-specific risk

The dominant risk – and opportunity – in a smaller-companies portfolio is stock-specific risk. A quantitative screen can highlight where to look for these opportunities. But fundamental analysis provides investors with a deeper understanding.

Portfolio managers who meet with company-management teams can assess those aspects of investment that are hard to quantify, such as corporate strategy. Investors need judgement to understand environmental, social and governance (ESG) risks. ESG analysis is not only a necessary step in understanding risk, but also allows investors to encourage companies to change their behavior. And it provides scope for investors to profit from changes to ESG ratings.

"The dominant risk – and opportunity – in a smaller companies portfolio is stock-specific risk"

Finding alpha in academic literature

Smaller companies have delivered strong performance since the turn of the millennium. Yet the asset class remains under-researched by academics. The little research that has been done offers encouragement to stock pickers. It also offers insights to asset-allocation strategists considering their exposures to smaller companies.

A search of the Financial Analysts Journal going back to 2000 reveals just four papers on smaller companies. Each provides an interesting angle for active investors.

Profiting from index rebalancing

Long-Term Impact of Russell 2000 Index Rebalancing (2008) by Jie Cai and Todd Houge examined the performance of companies added to and removed from this most widely followed index of US smaller companies.20 They found that a portfolio ignoring changes and following a buy-and-hold strategy outperformed the rebalanced index by over 2% per annum (from 1979-2004). The authors established that index deletions had provided significantly higher returns than index additions (adjusting for factor exposures).

They explain that “Part of these excess returns can be explained by strong short-term momentum effects. Stocks with good performance grow too big for a small-cap index and continue to have superior performance after being deleted from the index; stocks with poor performance become small enough to enter the index but continue to generate low returns.”

“Active investors in smaller companies can exploit the full range of return premiums on offer in markets. Momentum, low volatility and income strategies have provided long-term excess returns, alongside value.”

Active managers, who can choose whether to adjust their portfolios in response to index changes, were able to benefit from this. The strongest-performing funds held onto stocks that had been deleted from the index, avoided index additions, or both. The authors concluded that “index methodology may provide a structural incentive for portfolio managers to drift from their benchmarks”.

Extracting value from the ‘accruals anomaly’

Investors in smaller companies can exploit the ‘accruals anomaly’ to deliver outperformance. A seminal paper written by Professor Richard Sloan in 1996 identified that investors were overly focused on the bottom-line earnings, without sufficient consideration of the quality of those earnings.21 This left scope for investors to outperform by favoring companies where more of their earnings came in the form of cash flow rather than accrued income.

This anomaly was an example of a market inefficiency rather than a structural risk premium. Once investors spotted it and codified into trading algorithms, it largely disappeared. However, The Accruals Anomaly and Company Size (2008) by Dan Palmon, Ephraim Sudit and Ari Yezegel found that this opportunity persists for smaller companies.22 Higher trading costs meant the anomaly had not been arbitraged away.

Finding value (and other factor returns) in smaller companies

Active investors in smaller companies can exploit the full range of return premiums on offer in markets. Indeed, Disentangling Size and Value (2005) by Rob Arnott found that ‘When the size effect is separated from the value-versus-growth effect, size as measured by market cap is seen to be far less powerful than is generally believed and the value effect becomes more powerful and more consistent than generally believed’.23 In other words, much of the historic premium return from smaller companies comes from the fact that these stocks are cheaper, rather than because they are smaller.

Beyond the Financial Analysts Journal, The Numis Smaller Companies Index 2018 Annual Review studies style returns.4 It found that momentum, low volatility and income strategies have also provided long-term excess returns to investors in smaller companies, alongside value.

Information in international flows

Asset allocators considering an exposure to smaller companies need to understand that international investor flows can influence the small-cap premium. The Impact of International Institutional Investors on Local Equity Prices: Reversal of the Size Premium (2011) by Hau Jiang and Takeshi Yamada analysed performance over the period between 1995 and 2008.24 The size premium went into reverse in Japan during this time. They observed that international institutional-investor ownership of Japanese shares increased threefold over this period. These investors showed a preference for large-cap stocks. In some ways, Japan is a special case. Its economy was in a very different cycle for much of this period. However, country-specific risk is very much back on the global agenda. Brexit, the election of a populist government in Italy and President Trump’s pursuit of an America First agenda may share common drivers, but they are local affairs.

Investors can look beyond dedicated smaller company research for useful lessons. Mononationals: The Diversification Benefits of Investing in Companies with No Foreign Sales (2017) by Cormac Mullan and Jenny Berrill reveals its conclusion in its title.25

A portfolio of companies with domestic-only sales offers an antidote to the integration of financial markets. These mononationals are primarily smaller companies.

Of course, the investment community has not ignored the small-cap premium. Instead it has been embraced by a new breed of investors: quant investors employing smart beta strategies. The flow of money into these strategies may have been one ingredient in the outperformance of smaller companies since the turn of the millennium. However, these investors are typically buying every index constituent. For active managers willing to undertake fundamental research, this trend may increase the scope to add value above the index.

“Active investors in smaller companies can exploit the full range of return premiums on offer in markets. Momentum, low volatility and income strategies have provided long-term excess returns, alongside value.”


The study of the small-cap premium is one area of investment where academics have mostly led and investors followed.

  • 19641964 Bill Sharpe published Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. This introduced the concept of beta as the market return. It provided a one-factor model of the market. This proved to be a key ingredient in the development of the idea that markets are efficient. It played an important role in the birth of passive investment.
  • 19711971 NASDAQ was launched, introducing the era of all-electronic trading. It opened as an electronic exchange in 1981. Today approximately 3,900 companies have chosen to list on their US, Nordic and Baltic exchanges.
  • 19801980 The Unlisted Securities Market launched in the UK. Companies could float as little as 10% of share capital. They did not require the three-year trading history of the main market. The market closed in 1996.
  • 19811981 Rolf Banz published The Relationship Between Return and Market Value of Common Stocks. He examined the performance of New York Stock Exchange constituents back to 1926. He found that the smallest 50 stocks outperformed the largest 50 by 1% per month. This challenged the idea that markets were efficient. These returns came with greater risk. But the scale of outperformance was sufficient that risk-adjusted returns were well ahead of larger companies. This outperformance of smaller companies over large became known as the small cap premium. Smaller companies underperformed during the Great Depression but raced ahead after 1975. Practitioners were quick to latch on to this opportunity. Investment managers launched a number of dedicated small-cap funds soon after.
  • 19841984 The Russell 2000 index was launched, now the most widely tracked US small-cap index.
  • 19861986 Professors Dimson and Marsh from the London Business School published a study of the small-cap premium in the UK. Their research provided the underpinnings of the Hoare Govett Smaller Companies Index, launched the same year (now the Numis Smaller Companies index). By the end of 1988, at least 30 open or closed-ended funds investing in UK smaller companies had been launched.
  • 19931993 Fama and French published research on a three-factor model, which included value and size factors alongside the market factor in explaining stock market performance. By adopting a long-short strategy – buying small companies and selling large, buying lowly valued companies and selling highly valued shares – they showed that investors could isolate these sources of return from the overall market return.
  • 19951995 AIM was launched as the London Stock Exchange’s international market for smaller-growing companies, replacing the Unlisted Securities Market. Over 3,600 companies have joined the exchange since launch.
  • 1999In 1999 Dimson and Marsh provided an update on their work (Murphy’s Law and Market Anomalies). It highlighted that the small-cap premium had gone into reverse. The strong relative performance of US smaller companies that started in 1975 peaked in 1983. A sustained period of underperformance between 1984 and 1997 saw the long-term premium from owning small-cap turn from positive to negative. This led Dimson and Marsh to refer to the small-cap effect, the tendency of smaller companies to perform differently from larger companies. They questioned the existence of the small-cap premium.
  • 20012001 The MSCI World Small Cap Index was launched, followed by the FTSE equivalent in 2003.
  • 20022002 Dimson, Marsh and Staunton published Triumph of the Optimists. This book provided returns across equities – large and small – for 16 countries over 101 years back to 1900. This demonstrated that a smaller companies premium had been a global phenomenon. Smaller companies had outperformed in 15 of the 16 countries covered over the full 100 years. They have since provided an annual update of the data, now released as the Credit Suisse Global Investment Returns Yearbook.
  • 20042004 The JASDAQ automated quotation system, operational in 1991, was reorganized as a securities exchange - the first new Japanese exchange in almost 50 years.
  • 20072007 The MSCI All-Countries World Small Cap Index was launched, adding coverage of 24 emerging markets.
  • 20092009 Ang, Goetzmann & Schaeffer published The Evaluation of Active Management of the Norwegian Government Pension Fund. The authors concluded that the fund was not really actively managed at all. Instead, the performance had been driven by a small number of systematic factors. These could be replicated through rules-based approaches. Arguably, this paper lit the fuse for the boom in smart beta, both in academic studies of alternative risk premiums and in the launch of related products.
  • 2017The 2017 edition of the Investment Yearbook from Dimson, Marsh and Staunton provided an overview of factor investing from an historical perspective. It includes an updated view of the small-cap effect, with coverage extended to 23 countries over 117 years. Viewed internationally, smaller companies had given a long-run premium, relative to larger companies, averaging 0.3% per month.

    This edition compared results to the studies carried out by Banz in 1981 and Dimson and Marsh in 1986. The premium they found in the 2017 study was smaller, more often negative and more volatile. This led the authors to conclude: “if researchers were for the first time investigating the long-run returns on smaller companies, they would today recognize the small-firm effect (the tendency of small caps to perform differently from large caps) and would note that there had been a modest small-firm premium. But the magnitude of the premium would command less attention than in the past, and would not suggest there was a major 'free lunch' from investing in small-caps.”



Smaller companies are too big of a portion of the global investment universe to ignore. They offer the potential for a return premium for long-term investors. They bring diversification benefits through exposure to different risks. And the combination of a large universe and fewer analysts provides scope for active managers to add value above the index return.

‘Junior’ stock markets have lower barriers to entry to encourage new firms and new industries to develop. Historically this has translated into higher risk and lower returns for investors in these markets. But as these markets mature, they offer opportunities for selective investors to find high-quality opportunities.

“Investing in smaller companies opens up the opportunity to find compelling investment ideas that others have yet to discover.”

Smaller companies are different from their larger peers on many levels. Understanding the differences allows investors to achieve a better balance of risk and return.

Academic literature offers encouragement to stock pickers. The lack of analyst coverage and higher trading costs means that well-known anomalies persist in the universe of smaller stocks.

Investors should not buy smaller companies simply because they are small. Yes, smaller companies are expected to outperform their larger peers over the long term. But this return premium simply reflects the higher risks involved.

But investors shouldn't ignore smaller companies simply because they are small. Investing in smaller companies opens up the opportunity to find compelling investment ideas that others have yet to discover.


We acknowledge the work of Paul Marsh and Elroy Dimson, Emeritus Professors of Finance at London Business School. Together, they designed the Numis Smaller Companies Index (previously the RBS Hoare Govett Smaller Companies Index).

1 Professors Dimson, Marsh, Staunton and Evans, London Business School, CRSP, Morningstar (2018).

2 MSCI Index Factsheets (Dec 2018).

3 Rolf Banz (1980), The relationship between return and market value of common stocks, Journal of Financial Economics. This study somewhat overstated the historical outperformance of smaller companies because there was no adjustment for survivorship bias.

4 Scott Evans, Paul Marsh, Elroy Dimson (2019); Numis Smaller Companies Index 2019 Annual Review.

5 Robert N. Eberhart, Charles E. Eesley (October 2018), The dark side of institutional intermediaries: Junior stock exchanges and entrepreneurship, Strategic Management Journal, Volume 39, Issue 10.

6 Chris Mallin & Kean Ow-Yong (2012), Factors influencing corporate governance disclosures: evidence from Alternative Investment Market (AIM) companies in the UK, The European Journal of Finance, Volume 18, Issue 6.

7 Historical AIM statistics, London Stock Exchange (Dec 2017).

8 Jonathan B. Berk (Sept/Oct 1997), Does Size Really Matter?, Financial Analysts Journal.

9 E. Lecubarri et al., J.P.Morgan (09/12/2017), The Case for SMid.

10 Aberdeen Standard Investments, Bloomberg, 01/31/2018.

11 Gillian Tett (2015), The Silo Effect.

12 MSCI World Index factsheet (Feb 2018).

13 MSCI Korea Index factsheet (Feb 2018).

14 Worldscope/Factset (Dec 2018).

15 iShares (Dec 2018).

16 Bloomberg (2016).

17 Scott Evans, Paul Marsh, Elroy Dimson (2018); Numis Smaller Companies Index 2018 Annual Review.

18 Factset (Dec 2017).


20 Jie Cai and Todd Houge (2008), Long-Term Impact of Russell 2000 Index Rebalancing, Financial Analysts Journal.

21 Richard Sloan (July 1996), Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?, The Accounting Review, Vol.71, No. 3.

22 Dan Palmon, Ephraim Sudit and Ari Yezegel (2008), Accruals Anomaly and Company Size, Financial Analysts Journal.

23 Rob Arnott (2005), Disentangling Size and Value, Financial Analysts Journal.

24 Hau Jiang and Takeshi Yamada (2011), The Impact of International Institutional Investors on Local Equity Prices: Reversal of the Size Premium, Financial Analysts Journal.

25 Cormac Mullan and Jenny Berrill (2017), Mononationals: The Diversification Benefits of Investing in Companies with No Foreign Sales, Financial Analysts Journal.

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Important Information

Past performance is not an indication of future results.

Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security.

Diversification does not ensure a profit or protect against a loss in a declining market.

Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.


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