The Ultimate Alternative Investment

Servo’s Eric Nelson shows that small-cap stocks don’t magnify the gains or losses of large stocks, but actually move countercyclically and outperform

Eric Nelson of Servo Wealth argues that small-cap stocks are an asset class in themselves. Eric Nelson of Servo Wealth argues that small-cap stocks are an asset class in themselves.

Advisors looking for exotic alternative asset classes to diversify their portfolios have an option right under their noses that may be more accessible and profitable than lumber or vintage wine: small-caps.

Yes, you read that right. While advisors immediately grasp the ease involved in small-cap investing, Eric Nelson of Servo Wealth Management makes the underappreciated case that small-caps function as a separate and countercyclical asset class.

In his latest blog post, the analytically inclined advisor seeks to demonstrate just how different small-cap stocks are from their large-cap brethren.

Investors, he says, tend to view small-caps as mere extensions of the large-cap market — “a riskier subset of a total stock index that will do relatively worse when stocks are declining and relatively better when stocks are appreciating.”

Nelson calls this notion “completely wrong,” a point he emphasizes through a comparison of large-cap and small-cap returns during four market cycles over the past three decades.

From 1982 to 1990, large-caps generated 16.3% annualized returns compared with 8.9% for small-caps — and this wide variance occurred despite the fact that the beta (a measure of sensitivity to market movements) for the Dimensional Fund Advisors US Micro Cap fund (DFSCX) was nearly perfectly correlated with the S&P 500.

Again we see a huge performance gap—this time in the opposite direction—from 1991 to 1994, where DFSCX earned 22.1% compared with just 11.9% per year for the S&P 500. This despite the fact that their betas were nearly the same (and indeed micro-caps’ beta was less than that of large-caps).

In the next period, from 1995 to 1999, small-caps generated annualized returns of 18.5%, but large-cap returns were in another league at 28.6% per year.

“A more volatile subset of the market would have been expected to earn 5% to 10% more than the market, but instead did -10% less,” writes Nelson, whose broader point is that the two market segments simply do not move in lockstep.

That is seen again in the fourth time period, from 2000 to 2013, when U.S. stocks returned a paltry 3.6% per year compared with 10.4% for DFSCX.

(While Nelson uses a microcap index as his benchmark, he tells ThinkAdvisor that “what I say about microcaps holds equally true for small-cap stocks,” noting the performance of DFA’s small-cap and micro-cap funds were just 0.6% apart from 2000 through 2013. Microcaps represent the smallest 5% and small-caps the smallest 10% of the market.)

So not only do small and large stocks zig and zag quite differently, but their expected returns vary markedly as well.

Over the entire 1982 through 2013 period, the small stocks returned 12.6% per year—a result identical, Nelson writes, to the segment’s returns between 1926 and 1981. The S&P 500 came close to that over the past three decades (11.5%), but Nelson says that’s an anomaly, since large-caps returned just 9.1% between 1982 and 2013, fully 3.5% less than the long-term results that small stocks generated.

From 1926 to the present, small-caps trump large-caps by about 2% a year (and by 3% to 4% for small-value, Nelson tells ThinkAdvisor).

But advisors looking to capture of some this excess return need not consider either active funds or index funds, the DFA enthusiast says:

“While small cap stocks — and small value in particular — are very beneficial portfolio additions, you have to be careful how you invest: diversification, costs, and careful implementation are paramount.  First, there is no evidence that active managers add any value, so you could wind up taking ‘small-cap’ risk with an active manager…but only getting large-cap returns due to poor selections or unnecessarily high fees — this despite the belief that small caps are a less-efficient asset class,” Nelson says.

“But plain vanilla index funds are no panacea, either,” he continues. “Since 1982, the Russell 2000 Index — the only ‘retail index’ with a track record that old — with no fees deducted…trailed the DFA US Micro Cap fund by 1.8% per year!  And despite the fact that small stocks did beat large ones over this period …the Russell 2000 actually underperformed the S&P 500!”

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