Tilting toward small-cap stocks alone isn’t a great way to improve long-term performance. Small-cap stocks have historically offered a small edge over their larger counterparts, but that slight return advantage wasn’t much compensation for their higher risk and decade-long stretches of underperformance. However, other factors, like value, momentum, and low volatility, have tended to work better among smaller stocks. Deliberately targeting small-cap stocks with these characteristics will likely be more fruitful than a broad-based approach to investing in a broader cross section of smaller firms.
The payoff to the value factor offers a stark illustration. Exhibit 1 shows the returns on 25 portfolios of U.S. stocks formed on the basis of stocks’ size and book/price ratios (a measure of value, with larger values indicating relatively cheaper stocks). I’ve sourced this data from the French Data Library for the period from July 1963 through May 2017. Each portfolio has roughly the same number of stocks and is market-cap-weighted, so the small-cap portfolios represent a smaller portion of the market than the large-cap portfolios. All portfolios are updated once a year at the end of June.