U.S. Small Caps: Smoke And Mirrors

by: Julien Messias


The aim of this quick study is to check whether the well-known outperformance of US small caps over US large caps:

Is true?

Is persistent with respect to market timing?

Is persistent with respect to internal selectivity within the index?

Every investor - rookie or experience - already would have heard about the well-known, small caps' outperformance. The topic is not as simple as it seems to be. It has to be followed very cautiously. This article is an attempt to give readers some major keys, enabling them to avoid expensive mistakes.

This study relies on two indices:

- S&P 500 Total Return

- Russell 2000 Total Return

Database stands between December 31, 1998 and December 22, 2015.

Persistent with Market Timing?

We can notice that an investor who checked their performance at the end of each year, and who had kept their equity position until December 22, 2015 would have noticed an outperformance of S&P 500 versus Russell 2000 no matter they had invested at the end of 2004, 2005, 2006, 2007…or 2014. This outperformance varies between 1.7% (investment at the end of 2007) and 24.9% (investment at the end of 2010).

Therefore, the post 2008 rally in equities was clearly driven by large caps (here through S&P 500) over small caps (here through Russell 2000).

In the table below, the outperformance of large caps is exhibited in the bottom right. Everywhere else in the table, and whatever be the holding period, the Russell 2000 has posted a better performance than the S&P 500. The only period in which we notice a similar outperformance by the S&P 500 was during the equity market crash in 2007-2008 as large caps were being considered safer than small caps - a case of clear defensive reaction.

The rally that followed enabled the US equity markets to rise by 162.3% for the S&P 500 since December 31, 2008 and by 150.5% for Russell 2000 since December 31, 2008. Please note that between December 31, 2010 and December 22, 2015, the S&P 500 rose by 80.2% whereas Russell 2000 posted 'only' a 55.3% growth.

There is one explanation for this: the market has changed, with the increase in ETF investing, smart-beta and systematic strategies.

Source: Author's ownPerformance of S&P 500 Total Return - Russell 2000 Total Return

The 15.9% number in the table shows the difference between S&P 500 Total Return and Russell 2000 Total Return between December 31, 2010 and December 22, 2014.

From the table we can infer that until 2010, the Russell 2000 has been outperforming the S&P 500 regularly, except in 2007-2008, where the 'washout' was much more important for small caps than for large caps. It seems that since 2010, investor behavior has changed with a big shift towards ETFs and smart-beta, risk premia solutions, focusing on large caps and low-volatility assets (Minimum Variance method, Equal Risk Contribution).

Persistent with Internal Selectivity Within the Index - Actuarial and Total Return

We check the composition of each index at the last day of year Y-1, and assume the composition remains stable over year Y. Given the huge rotation of US indices, it is a way to minimize the error due to index reshuffle and to birth and death sample bias.

Source: Author's own

Look at the 1999 table. The Russell 2000 posted a 21.3% performance, with an average performance of the components of 25.6%. The median is -7.6%! almost 30 points low.

Except in 2002, the median performance of the Russell 2000 components has been always below the average performance, or below the performance of the Index.

Two explanations:

- The median performance of the components is lower than the average performance.

This means that the distribution exhibits excessively large returns on the positive side, dramatically shifting the average return on the upside.

- The average performance of the components is lower than the index performance.

This means that these indices, being capitalization-weighted, give more weight to large capitalizations. Therefore, large capitalizations tend to outperform small, even within the Russell 2000 Index.

Shown below is the distribution of the annual performances of the components from S&P 500 and Russell 2000.

Source: Author's own

These distributions are very interesting, especially focusing on the extreme left tail, the right hand part of the body and the extreme upper side of the distribution.

Without any surprise, tails are a lot thicker for Russell 2000 than for S&P 500. Moreover, on Russell 2000, best annual performances exceed 1000%.

Question is: Given the well-known investor asymmetry between gain and loss, do you think that a stock which is up 100% YTD will be kept in the portfolio by the asset manager? Don't you think that he would cut the position in order to 'take his profit'? Therefore, in a stock-picker paradigm, and given the behavioral and cognitive biases, it can be considered as very difficult to keep a large (>100%) winning position. Thus, the contribution of positive extremes to the Russell 2000 cannot be taken into account in a stock-picking framework. Using medians in order to measure each stock performance seems then a much more reasonable assumption (look below).

Source: Author's ownPerformance of S&P 500 Total Return - Russell 2000 Total Return, calculating using the median of the return of the components, year after year. These returns are capitalized over time.

This table shows the difference between the median of S&P 500 and the median of Russell 2000. Since 2004, the median of S&P 500 outperforms regularly the median of Russell 2000. In other words, if your stock-picking is not able to catch the extreme positive returns on Russell 2000, then you should shift to stock-picking within S&P 500, as the best proxy of your expected return (the median) is by far higher on the latter index.

On the other hand, should you be interested in investing through ETFs, then you can choose to invest in Russell 2000 ETFs rather than in S&P 500 ETFs as you get the performance of the index. Until 2010, the Russell 2000 Index used to outperform S&P 500 regularly.

Within the Russell 2000, may we exhibit any pattern?

In the image below, colors are important - the more positive, the greener, the more negative, the redder. Rows stand for capitalization quartiles, from the smallest (top) to the largest (bottom). Columns stand for volatilities quartiles from the smallest (LHS) to the largest (RHS).

Source: Author's own

Looking at the performance (capitalization (row); volatilities (column)), we can notice that although over the period, the performance of the index is largely positive (+249% total return between December 31, 1998 and November 11, 2015) - meaning it was a bull market on average 7.7% per year, the red cells are much more represented on the right column of the table. This happens when the index performance is negative, of course (2002, 2008), but it also happens when the index performance is flat or mildly positive (2000, 2001, 2004, 2011, 2012, 2014, 2015).

On the other hand, these high volatility stocks strongly outperform the universe in two periods out of seventeen: 1999 and 2003, with respective total return performance of the Russell 2000 of +21%, +47%.

This means that the outperformance of volatile small caps is very hard to capture because over the long run it may be easy to experience huge drawdowns with difficulties to recover. Keep in mind that when a stock drops by 50%, it needs to increase by 100% to come back to the initial level.

Regarding capitalization effect, things seem to be more difficult to explain.

As a summary for this part, should you want a smooth pattern, focusing on the low-volatility stocks in N-1 is worth in order to succeed in such a challenge, whereas dealing with historically high-volatility stocks may suffer from huge drawdowns (2002, 2008), and only rare astonishing performances, which may struggle in erasing the previous underperformance.

The issue is always the same: what is your investment timeframe? For more information: Why US investing differs a lot from European investing


Due to the weight of extreme returns, the performance of Russell 2000 is pulled up dramatically. Russell 2000 is a non-representative index of small caps given that the small caps universe can be summarized as "many are called, but few are chosen," but the ones which are chosen exhibit amazing performances (more than +1000% per year) hiding the many which are not chosen and post performances close to -100%. The asymmetry of actuarial returns (compared to logarithmic returns) then emphasizes these extreme positive returns whose upper limit is + infinity, whereas a stock price cannot go below 0, flooring the extreme bad performance to -100%.

Second, given the asymmetry of the investor with gain and loss, these extreme positive returns are not sustainable in a stock-picking framework, as everybody knows that investors are likely to take profit on a largely winning position, meaning that it is very unlikely that they keep an equity position whose performance already equals +100% per year. Therefore, studying the small cap universe through the mean does not seem to take this behavioral bias into account. Using the median seems more relevant.

In addition to the data explained, investing in US small caps by picking stocks from the Russell 2000 means struggling with scarce liquidity.

In a nutshell, should you want to invest in small caps, do it through a Russell ETF; should you want to pick up stocks, you should rather choose an S&P 500-equivalent universe, as the left tail of the distribution of S&P 500 is a lot thinner than the one of Russell 2000.

The development of ETFs and the increasing flows on these strategies and smart-beta and risk premia are likely to increase the pattern we exhibit in this paper.

So from now, when speaking about the outperformance of small caps, you can say, "Small caps are smoke and mirrors. Should you want to outperform the S&P 500, you have to be good at picking the stocks (the famous 2% positive extremes), AND you have to be good at timing the market"

Companies whose aim is to pick up US Small Caps almost always underperform the Russell 2000 (Median Performance of the Members < Index Performance). Now you are able to understand why. Would you rationally invest in such a strategy? (Too?) many people are convinced that they have the skills to pick up the famous 2% stocks that post astonishing performances. Be careful as too much self-confidence is likely to turn into overconfidence and a long-term underperformance.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.