Small and mid cap stocks have been on a roll thus far in 2010.  Indeed, investors in small caps have done extremely well in virtually every time period over the past 15 years.  Can that dominance continue or is it true that, like gravity, all investment styles that rise eventually fall?  Later in this posting we’ll suggest some ways to position your portfolio management strategy so as to include small caps if you think the good times are going to roll on.  Meanwhile let’s take a look at the actual data to see what is going on.

The following table shows the performance of Russell large, mid and small cap indexes over selected time periods ending at the present.

All figures expressed as average annual total return (appreciation + dividends) for the period in question.
Source: Russell Investments Index Calculator

A quick word about methodology.  The Russell indexes rank publicly traded companies by market capitalization, so that the Russell Top 50 and 200 contain the 50 and 200 highest market cap stocks respectively.  The Midcap Index contains the next 800 stocks by market cap, with the Russell 2000 denoting the next 2000 names, regarded to be small cap stocks.

The remarkable thing about this chart is that for every time period going back 15 years the small and mid cap indexes have outperformed their largest-cap peers – and not by just a little bit, but by a considerable margin.  Just in the last year the returns on small/mid cap stocks have been more than triple those of the biggest companies.  Is there any discernable reason for this type of sustained outperformance?

There are several plausible reasons why this discrepancy exists, and there is also a case to make that things may look somewhat different going forward.  Let’s first argue the small/mid cap rationale.

Academics first noticed the tendency of smaller cap stocks to outperform their larger-cap counterparts several decades ago, giving rise to the “small cap effect” as a plausible investment strategy.  One of the arguments for this is that traditionally smaller cap stocks are not as heavily covered by research analysts, they are not as liquid in terms of daily shares traded, and they are not as widely held by institutions as large cap names.  All of those characteristics can make small cap shares more volatile in day to day trading.  Over time, that volatility can translate into higher returns (assets with higher risk properties are expected to exhibit higher returns over long term periods while being vulnerable to more dramatic ups and downs in the short term).

Small cap stocks also tend to do well in the first year or so after the market has recovered from a previous fall.  In 2003, the first recovery year after the 2000-2002 dot-com collapse, small cap stocks exhibited considerable outperformance.  They can also perform well in what investors call “junk rallies”, when investors tend to be excited about stocks in general and don’t care as much about the quality of the company, thinking they are going to get substantially higher returns for taking on more risk.  Such market conditions existed in the second half of 2006 and are believed to have been prevalent again in the run-up over 2009-10 (which was also, of course, a recovery market).

The other factor that might be causing such a distinct performance gap is that the Top 50 and Top 200 indexes contain a disproportionate number of large financial institutions.  We know that in the 2008-09 market crash shares in these companies were beaten down considerably farther than other industry sectors, and no doubt dragged the indexes down with them.

Having said all that, there is a case to make for the return of the super-large cap (sometimes just called super cap).  Right now there are really two fundamental factors driving the high corporate earnings figures we have seen in the last couple quarters.  One is geographic reach: quite simply, companies that derive considerable amounts of revenue from non-US markets, and especially from the fastest-growing markets in Asia and Latin America, are growing faster.  The second is investment in productivity enhancement – tools and processes to squeeze more profit out of every revenue dollar.

Those factors decidedly play into the hands of the largest companies that have the resources to compete globally and invest the capital necessary to make their operations more efficient.  Moreover, these companies on average are carrying very low levels of debt on their balance sheet.  Households may be staggering under massive credit card and mortgage obligations, and the government may be spending like a drunken sailor, but corporations have plenty of cash in their coffers.

This could mean that we are about to see a reversion to strength by the super caps.  Investors who think that the collapse of financial stocks is largely over, and who see global growth resuming a vigorous pace, may be inclined to overweight the super cap space.  Of course there is no telling whether the timing for such as move is right or not – and investors have been burned on this kind of a call before.  Time will tell.

Meanwhile, if you think your portfolios can benefit from some small cap exposure, here are some funds to consider.  Exchange-traded funds (ETFs) managed by iShares provide access to a proxy for the Russell indexes: Russell 2000 Index (IWM) and Russell Midcap Index (IWR).  Or, if you want to play the other side of the trade, the Russell Top 200 Index also has an iShares ETF: IWL.

The Vanguard Small Cap Index Fund (NAESX) provides index-linked returns to the small cap space, as does Schwab Small-Cap Index (SWSSX) and BlackRock Small Cap Index I (MASKX).  Or, just set up your own Jemstep profile, set your preferences for small cap funds and see what funds come out at the top of  our mutual fund ratings!

TAGS: mutual fund analysis, mutual fund research, portfolio management