Why Small Caps And Quality Can Be A Powerful Combination

By Christopher Gannatti

In January 2015, Cliff Asness and his colleagues published a paper titled “Size Matters, if You Control Your Junk.”1 The big-picture concept of focusing on a fundamental attribute—in this case, quality—within small caps is something that we believe is quite powerful and something that WisdomTree has been doing when constructing its Indexes since 2006.

Quality: Long-Term Outperformance with Lower Risk

The “size effect” has been well documented, leading many investors to believe that holding shares of small companies for long periods of time could be a successful strategy. However, it’s important to question whether these greater returns over long periods are simply a function of greater risk.2

  • Small caps vs. the market: Small caps did beat the market by slightly more than 2% per year from June 30, 1963, to December 31, 2016, but this was with about 6% per year in incremental additional volatility. It’s notable that small caps had a lower Sharpe ratio than the market over this period by .0006—meaning that in risk-adjusted terms it would be difficult to say that small caps outperformed the market over this period.
  • Not all small caps are equal: In investing, what’s avoided is at times equally (or more) important than what is focused upon. Clearly, there are small-cap, lower-quality firms—specifically with lower operating profitability—that had lower returns and higher risk over this period.
  • Small quality: By avoiding the small caps with lower operating profitability and focusing on those with higher profitability, there was a return advantage over simply focusing on small caps alone. However, there was also a risk advantage, leading to a significant increase in the Sharpe ratio.

Conclusion: When investing in small caps, filtering out lower-quality, more speculative companies could be beneficial.

Cumulative Growth of $1,000 (6/30/196312/31/16)

How WisdomTree has Avoided Speculative Small-Cap Firms

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