Last quarter I mentioned that I’d be revisiting the methodology used to estimate the Small-Cap premium over Large-Cap Domestic Equities and, thus, the return estimates we use for Small-Cap index funds.
We have completed that review and are updating our methodology to reflect current valuations relative to historical averages and between Large- and Small-Cap Equities.
HISTORY
The initial research on Small-Cap premium, the higher return to be expected for investing in smaller companies vs. larger companies, was done in 1981 by Rolf Banz. It filtered into the textbooks and the CFA curriculum about the time I was earning my Charter and became part of Compton Advisors, LLC’s models when I started the firm. Things have changed since then both in terms of market structure and research. Alex Bryan at Morningstar offers an excellent summary. The major changes were:
More liquidity in Small-Caps: ironically, this was brought about, in part, by investor demand seeking to capture the premium and mutual fund families creating Small-Cap index products to meet this demand.
Companies waiting longer to go public and going public with larger market capitalizations shifting some of the return premium from public markets to private equity.
A realization that most of the premium came from Micro-Cap stocks (the smallest 5% in terms of market capitalization) – the least liquid securities and those most prone to the first two effects above.
As a result, the Small-Cap premium was roughly 1/3 of the original estimate in the three decades following the Banz study and, furthermore, not statistically significant. At the end of 2022, the rolling 20-year Small Cap premium was at its lowest point, nearly zero.
CHANGES
This has convinced me to say good-bye to a fixed Small-Cap premium and adopt a relative value approach. The practical results of this change are:
Adoption of a wider range of Small-Cap premiums.
Variable Small-Cap premiums based on valuation rather than fixed historical ranges.
The possibility of negative Small-Cap premiums (i.e., expected returns from Small-Cap less than that of Large-Cap) if valuations warrant it (e.g., the dot-com bubble).
A smaller current premium than we have been using in our models, suggesting a reduced allocation to Small-Cap Domestic Equities
We will begin using the new methodology with our January 2023 Advisors’ Outlook.