Is There Structural Alpha in the Small Cap Market?

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Is There Structural Alpha in the Small Cap Market?

Larry Swedroe May 19, 2016

The Less Efficient Small-Cap Market

The authors present seven arguments for why there’s structural alpha to be had in small-cap stocks.

1. The number of analysts covering small-cap equities is significantly smaller than the number of analysts covering large-cap equities. This provides greater opportunity to uncover valuable information.

2. Publication frequency by analysts is significantly lower for small-cap stocks than it is for large-cap stocks. These less-frequent updates create “more uncertainty around earnings estimates and pricing for these companies and, hence, more opportunities for talented stock-pickers to generate alpha.”

3. The dispersion of analyst forecasts is higher for small caps. Higher dispersion creates more uncertainty, and so provides greater opportunity.

4. The largest hedge funds gravitate to large-cap stocks. Thus, there is less information competition in small-cap stocks.

5. The majority of event activity (mergers and acquisitions) occurs in small- and mid-caps, resulting in greater opportunity. The authors write: “Elevated levels of corporate activity tend to drive misunderstanding and mispricing in public markets (e.g., companies undergoing corporate change may engender complex situations), and when combined with the generally reduced informational flow for small caps, may lead to opportunities to extract an analytical advantage. Furthermore, the higher incidence of catalysts in this space (evidenced by the high transaction count) can allow this potential analytical edge to be exploited to a greater degree.”

6. It pays more to get it right in small caps. The authors also cited a study by RBC Capital Markets, “The Value of Perfect Foresight,” that measured the return of perfect foresight on firm earnings, revenue or margins for two sets of companies. Using the S&P 600 as a proxy for the small-cap universe and the S&P 500 for the large-cap universe, both groups were broken into quintiles based on earnings revisions during the month. At the start of each month, the strategy is long the top quintile and short the bottom quintile in each respective universe. If an investor had the luxury of applying this strategy on earnings revisions for small caps, he or she would have earned a 64.6 percent excess return compared to a 34.7 percent excess return by following the same methodology for large caps. Ranguelova, Feeney and Lu state: “Part of this difference can be attributed to the higher volatility of small-cap equities; however, the results strongly indicate how much less efficient the small-cap equity market appears to be.”

7. Idiosyncratic factors matter more for small caps. The authors write: “Stock-specific influences drive approximately 80% of the small-cap opportunity set as opposed to approximately 60% for large caps.” This creates an increased opportunity set for small caps.

Data Findings

Data Analysis

Turning to the small-cap asset classes, where Ranguelova, Feeney and Lu concluded that “small-cap equities remain a more fertile ground for differentiated stock picking due a number of structural inefficiencies,” the evidence tells another tale. Not only did funds from Vanguard and DFA outperform 79 percent of surviving actively managed small-cap mutual funds, but these results are even stronger than the 70 percent of actively managed large-cap funds that they outperformed.

Investors are becoming increasingly aware of just how much of a loser’s game that active management is (and acting on that knowledge). According to Morningstar, in the first 11 months of 2015, investors added $362 billion to all passively managed stock and bond funds in the U.S. while pulling $140 billion from actively managed funds.

The Bottom Line

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