Factor-Based Investing – The Small Cap Premium
Decades of academic research have identified that there are systematic differences in expected returns based on what is commonly referred to as factors. We can exploit these factors to structure portfolios to target higher expected returns. An example is the small cap premium.
Persistent and Pervasive Factors
While there is no guarantee that these factors will continue to out-perform over time, empirical evidence has suggested that these factors have been persistent (i.e., occurred over time) and pervasive (i.e., occurred over the equity markets in various geographical regions).
4 “Premiums” of Return
Over the next several weeks, we are discussing the four factors that have been shown to be persistent and pervasive. These factors give rise to “premiums” of return. These premiums are:
- Equity premium
- Small cap premium
- Value premium
- Profitability premium
To be considered a dimension of expected return, a premium must be all of the following:
This week: The Small Cap Premium
This week we are going to take on the small cap premium. The small cap premium is based on empirical evidence (i.e., data) that suggests smaller companies will outperform larger companies.
The small cap premium – applying the basics of mathematics
To help understand why this makes sense intuitively, let’s consider Apple:
- Market capitalization represents the value of the companies in a particular market. Essentially, you add up the total of the number of shares of each company when multiplied by their current price. For US based companies, that’s around $30 TRILLION dollars.
- Apple has a market capitalization of around $1 TRILLION dollars
- That means that Apple’s “value” (as expressed by market capitalization) is a bit over 3% of the total value of the US market.
PUNCHLINE – Apple may want to “take over the world,” but it’s going to be difficult to do so given the above numbers!
Smaller companies only have to make smaller ABSOLUTE increases to achieve larger PERCENT increases.
The small cap premium is really nothing more than a restatement of a mathematical fact: to get an equal percentage increase a larger number will require a larger ABSOLUTE increase than a smaller number. 10% of 1 trillion is $100 billion. 10% of $100M is $10M. Smaller companies only have to make smaller ABSOLUTE increases to achieve larger PERCENT increases. It’s math folks!
The small cap premium – both persistent and pervasive
The small cap premium has been shown to be persistent and pervasive. For that reason, a portfolio that “over weights” or “leans” into smaller capitalization companies has been shown to have a higher expected return over the long run.
In upcoming weeks, the other 2 premiums
In the following weeks, we will go through the value and profitability premiums. Each of these premiums will also have a logical, easy to understand explanation that backs up what the academics have found. For this reason, I have a high degree of confidence in using a factor- based approach to investing, which is built on leveraging these premiums.
Would You Like More Support?
- Do you have a well-defined Investment Policy Strategy that is used to drive your investments in support of a comprehensive financial plan?
- If not, would you like to partner with someone who is used to helping people get through these struggles and (then, with confidence) implement portfolio strategies in a systematic manner while focusing on your desired outcomes?
If so, feel free to send us an email or give us a call. We’d love to have the opportunity to help you find a bit more peace of mind when it comes to investing.
F5 Financial is a fee-only wealth management firm with a holistic approach to financial planning, personal goals, and behavioral change. Through our F5 Process, we provide insight and tailored strategies that inspire and equip our clients to enjoy a life of significance and financial freedom.
F5 Financial provides fee-only financial planning services to Naperville, Plainfield, Bolingbrook, Aurora, Oswego, Geneva, St. Charles, Wheaton, Glen Ellyn, Lisle, Chicago and the surrounding communities; to McDonough, Henry County, Fayette County, Atlanta and the surrounding communities; to Venice, Sarasota, Fort Myers, Port Charlotte, Cape Coral, Osprey, North Port, and the surrounding communities; and nationally.
We'd love to have the opportunity to hear about your situation. Contact us here to schedule an appointment for a consultation.
Helping You With
Wealth Preservation – Wealth Enhancement – Wealth Transfer – Wealth Protection – Charitable Giving