The Small-Cap Premium: Construction, Explanations, and Drawdown Risks

Summary

The document describes the equity size effect: the claim that smaller-capitalization stocks can outperform larger stocks. Its basic portfolio sorts NYSE, AMEX, and NASDAQ stocks by market value into deciles, then buys the smallest decile and shorts the largest. It also distinguishes this long-short factor portfolio from a long-only small-cap allocation, which the text says can contribute to diversified portfolios. Possible explanations include trading illiquidity and costs, growth opportunities, business-cycle flexibility, innovation, and greater risk.

The evidence is mixed and includes a reported drawdown of nearly 80% for the pure size strategy in the 1990s, alongside cited research examining size across periods and markets. The document warns that small caps have not served as a reliable hedge during stress and may be especially weak before crises. Research summaries also raise concerns about microcaps, market depth, transaction costs, inconsistent results, and sensitivity to controlling for firm quality. The effect's existence and practical investability therefore depend on construction, costs, and sample.

Key ideas

• The basic size portfolio buys the smallest market-cap decile and shorts the largest.
• A long-only small-cap allocation differs from the pure long-short factor strategy.
• Illiquidity, growth potential, flexibility, innovation, and risk are offered as explanations for the premium.
• The text reports severe historical drawdown risk and warns that small caps can weaken before crises.
• Research findings vary with market depth, trading costs, sample, and controls for firm quality.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.