Clock and Money

Are Small Cap Index Funds Poised for a Rebound?

Clock and Money

Small cap stocks have outperformed large cap companies this century over many longer-term periods. In recent years, however, the returns of large cap indexes have dwarfed those of small cap indexes. Does this signify the forthcoming dominance of small cap indexes? There are plenty of professionals who think so.

"Two-thirds of my personal portfolio is invested in small caps," says John Montgomery, who manages the Bridgeway Ultra-Small Index Fund. "Small companies are a little cheap and large companies are extremely expensive." Montgomery feels that the returns of small caps are likely to beat those of large caps over the next several years.

Long-term data suggests that the recent disparity in returns is a historical anomaly. From 1926-1996, small cap stocks gained a compound annual return of 12.6% compared to 10.7% for large cap companies according to Ibbotson Associates. Other long-term periods show different gaps, but many periods favor small caps.

Over the past fifteen years, the returns of large companies have greatly exceeded those of companies with smaller capitalizations. The Russell 1000 index of large companies returned 18.64 annually over the past 15 years compared to 13.23 percent for the small cap Russell 2000 index. The S&P 500 index of large companies gained 18.92 percent during the same period, as opposed to 12.60 percent for the S&P 600 index of smaller companies.

This difference is remarkable. At the annual rate of 18.92 percent minus a 0.5 percent annual fee, a $10,000 investment would be worth about $685,000 in 25 years, while assuming a 12.6 percent return minus the 0.5 percent fee, a small cap index fund shadowing the S&P 600 would leave you holding a paltry $174,000 after the same time period. Why invest in small cap index funds that are underperforming the big boys by such a wide margin?

Some experts suggest that the high growth potential and nimbleness of small caps accounts for the historic two percent edge for small caps, while a herd mentality is more responsible for the recent large cap runup.

Only time will tell if the recent dominance of large caps is temporary or if small caps no longer enjoy a long-term edge in returns.