Index Aug-04 QTD YTD Description
S&P 500 Index* 0.23% -3.21% -0.69% Large-cap stocks
DJIA* 0.34% -2.50% -2.68% Large-cap stocks
Nasdaq Comp.* -2.61% -10.24% -8.25% Large-cap tech stocks
Russell 1000 Growth -0.49% -6.11% -3.55% Large-cap growth stocks
Russell 1000 Value 1.42% -0.01% 3.93% Large-cap value stocks
Russell 2000 Growth -2.15% -10.94% -5.88% Small-cap growth stocks
Russell 2000 Value 0.98% -3.67% 3.88% Small-cap value stocks
EAFE 0.46% -2.78% 1.95% Europe, Australasia & Far East Index
Lehman Aggregate 1.91% 2.92% 3.07% U.S. Government Bonds
Lehman High Yield 1.96% 3.35% 4.75% High Yield Corporate Bonds
Calyon Financial Barclay Index** -1.84% -2.93% -6.28% Managed Futures
3-month Treasury Bill 0.67%

All returns are estimates as of August 31, 2004. *Return numbers do not include dividends. **Returns as of August 30, 2004.

The stocks of small companies have dramatically outperformed those of larger firms over the last five years. According to the graph below, a $1,000 investment in large company stocks at the beginning of 1999 would be worth about $950 today; that same amount invested in small company stocks would be valued at $1,400.

However, after five years of dramatic outperformance, it may be time to reevaluate small cap holdings. A big catalyst for such change is the current interest rate environment. Small companies tend to borrow money from banks at a variable interest rate, and as a result, the cost of operations of these smaller firms tends to be adversely affected as borrowing costs increase. As rates rise, so will the financing costs of small companies, which could make them less attractive.

Larger companies do not face this dilemma, because they typically borrow money by issuing bonds at a fixed rate of interest. This makes them better able to weather the storm of higher rates, while enjoying the benefits of an improving economy. The table below illustrates the performance difference between large and small company stocks in rising and falling interest rate environments. In a rising rate environment, large company stocks have clearly performed better.

Large Company Stocks Small Company Stocks
Rising rates Falling rates All periods Rising rates Falling rates All periods
Average monthly return 0.83% 1.23% 1.12% 0.22% 1.35% 1.05%

Data range: January 1979 — June 2004

Even though small stocks are pricier than their larger-cap counterparts, there are some advisors who still favor the little guys. Most subscribe to the hypothesis that since many smaller stocks have limited analyst coverage, their prices are slower to respond to improving company fundamentals. That may translate into opportunities for stock pickers, but for asset allocators like me, tilting toward large-cap index funds is probably a better route.

Ben Warwick is chief investment officer of Sovereign Wealth Management in Denver and the author of Searching for Alpha: The Quest for Exceptional Investment Performance (Wiley, 2000) and The WorldlyInvestor Guide to Beating the Market (Wiley, 2001). You can purchase these books at the IA Bookstore at