The Trouble With Return Anomalies

Is the small cap risk premium dead? The question endures for a rather practical reason: sometimes the excess return on small stocks vs. large companies evaporates. No one’s ever sure if it’ll return. That’s the nature of return “anomalies.”

The idea that you’ll earn a higher return for owning small stocks vs. large cap stocks is perhaps the most-famous of all the known return anomalies. It’s also no stranger to systematic efforts at trying to extract small cap performance gold, as the sea of dedicated funds in this niche reminds. The long run track record certainly looks encouraging, as many researchers have documented through the years. A recent study, for instance, reports a small-cap premium of roughly 200 basis points over large caps in the U.S. since 1926 (“The behaviour of small cap vs. large cap stocks in recessions and recoveries: Empirical evidence for the United States and Canada,” by Lorne N. Switzer). The international evidence in favor of small caps is also conspicuous (“Size, Value, and Momentum in International Stock Returns,” Eugene Fama and Ken French). But expecting the small cap premium to arrive arrive in steady doses is expecting too much.
In recent years, small stocks have trailed their larger counterparts, according to Russell Investments. Over the last five years through Oct. 14, 2011, large caps have a slight edge. Is that the new normal? The large-cap advantage is even greater over the past 12 months. Is that a sign of things to come? Or just a temporary failure?
The weak relative performance in small companies of late is merely the tip of the iceberg, according to recent claims that the small-cap premium is less than it’s cracked up to be once you adjust for risk. “The long-held belief that small stocks beat large on a risk-adjusted basis is simply not supported by the facts,” report Gary Miller and Scott MacKillop of Frontier Asset Management in the September 2011 issue of Financial Advisor.
Even if you disagree, recent history reminds that being a small cap investor is no easy road to riches. Should we be surprised? No, not really. Return anomalies, whether it’s the value factor, momentum, liquidity risk, or any of the long list of other identified sources of excess return, the future’s always uncertain.
We should be wary of becoming intellectually lazy when it comes to expectations of capturing higher returns over the broad market, either within an asset class or in a multi-asset class strategy. Everyone can’t earn above-average returns. In the long run, positive alpha is offset by negative alpha. That’s simply fate. A buy-and-hold strategy of overweighting small caps may work…if you wait long enough.
But timing may be crucial: there’s lots of opportunity for beating the benchmarks by reweighting risk factors. But higher returns aren’t a constant. Much depends on when you reweight… or don’t. Easier said than done. No wonder that in the long run the average investor (as defined by the market-value-weighted return) earns average returns—Duh! The rest of the story is that there must be below-average investors—no anomaly is excepted. Someone has to pay for the above-average results that some of us will earn.