Adding Small Caps to Your Portfolio

7/31/2019 Adding Small Caps to Your Portfolio

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Adding small caps to your

portfolioBy: Frank Armstrong, CFP, AIFIn our last column, we diversified internationally using thetraditional foreign asset class, Morgan Stanley's Europe,Australia, and Far East index (EAFE). EAFE is an index oflarge companies, including many multinationals, in developedcountries. Though an improvement, the results were distinctlyunder-whelming. As Rex Sinquefield pointed out in hispaper "Where Are the Benefits of International Investing?"the EAFE index fails to provide the benefits that internationalinvesting is supposed to bring, namely, increased returns and/orreduced risk.When you think about it, there is no good reason why a Germanought to expect far higher returns for investing in MercedesBenz than an American should expect from investing in Ford.Both companies share numerous common factors and traits. Weshould expect that such similar companies will over time havesimilar returns and costs of capital. Further, as both are large,multinational companies in developed countries with similarproducts competing in each other's back yards, we might expectthem to correlate closely. And they do. Their stock performanceis not entirely determined by local economic factors. It is alsostrongly affected by common international and automotivetrends.To achieve measurable benefits, we are going to have to lookfurther to find asset classes with higher returns and betterdiversification characteristics. It is not that international investingis a flawed idea, but that there are far better international assetclasses than EAFE to help us achieve our goals.
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The effects of style on investment returns

A pioneering work by Eugene Fama and Kenneth French

examined the effect of investment style on returns. We canthink of investment style as being the part of the market that weinvest in. To see what Fama and French discovered, let's startby dividing up the U.S. market by size of company from the verylargest publicly-traded firms to the smallest. On a scale of one toten, the S&P 500 might occupy the top three deciles, mid-capsand small companies would fall between deciles four and seven,and micro-caps hold down the bottom two deciles.

What Fama and French found was that in a period from 1963 to1991, micro-caps outperformed large stocks by about 5% peryear. As we might have suspected, small companies also havehigher risk. As we move down the deciles, rates of return and riskincrease rather smoothly.Their work reveals another nice feature, however. There is alow correlation between the performance of a market's largestcompanies and its smallest. They usually perform well or poorlyat different times.Now all this might have been just cocktail party trivia if thestudy hadn't been replicated for other time frames and variouscountries, with startlingly similar results. When many studies findsuch similar patterns, we begin to feel confident that there is afundamental economic factor at work.


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Most small companies do not have the international exposure oftheir bigger cousins. Their stock performance and returns aredriven more by local economic, political, and emotional factors

than are multinationals'. Small companies have low correlationsnot only with the largest companies within their own countries,but also with companies both large and small in other countries.As you remember from our discussion ofModern Portfolio Theory,if we mix risky asset classes with low correlations together, theresulting portfolio will have higher rates of return, but with lowerrisk than the average of the individual parts. It's only fair topoint out that as with all other diversification techniques, nothingworks every day, and there will be long periods of over- and

underperformance for the various sectors.

For instance, let's look at recent returns of the U.S. marketsagainst the foreign markets. From 1982 to 1990, large foreignstocks (EAFE) outperformed the large domestic stocks (S&P500) by 2.95% per year, while small foreign stocks beat smalldomestic stocks by a whopping 17.46%.

In the 1980s, foreign stocks trounced U.S. stocks on anannualized basis. In the 1990s, the reverse has been the norm.However, the situation reversed after 1990. The entire foreignadvantage vanished. Through September 1997, large-foreigntrailed large-domestic by 10.36% and small by 22.17%.
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Investors exposed to all four segments fared well throughoutthe entire period, but their happiness was generated by differentsegments at different times.

So, let's cut in half both our S&P 500 and our EAFE exposuresin our model portfolio, and replace them with two new assetclasses: domestic small companies and foreign small companies.

Now we observe a very gratifying increase in rate of return.Better yet, because of the low correlation of the new assetclasses to the ones we already held, we have managed to capturea fair share of the higher returns offered by smaller companieswhile avoiding almost all of their inherent risk. Neat stuff, huh?

Fama and French have another, more surprising, gift forknowledgeable investors. There is an additional dimension tothe style question that delivers even better rewards to properlydiversified investors. Check in our next installment for a trulyvaluable lesson.

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Adding Small Caps to Your Portfolio