The results produced over the years by small-company stocks are eye-opening. From 1926 through 2013, the annualized return for stocks in this category has been 12.3%, versus 10.1% for large-company stocks, according to data compiled by Ibbotson Associates, a Morningstar subsidiary.

While that advantage may seem modest, Ibbotson’s 2014 yearbook reports that $1 invested in small-company stocks would have grown to $26,641 in that period while $1 in the blue chips would have reached $4,677. (That hypothetical buildup assumes continual dividend reinvestment and no taxes; transaction costs are inferred for small-company stocks starting in 1981.)


Such a report might lead financial planners to include a small-cap fund in clients’ portfolios, but a closer look at the Ibbotson methodology can be valuable. “What people call microcap is actually the original small-cap asset class,” says Scott Leonard, founding partner of Navigoe, a wealth management firm in Redondo Beach, Calif. “It was the microcap data that got people excited about small-cap stocks in the first place. This all happened before Russell created its 2000 index, which consists of the bottom 2,000 of the largest 3,000 companies.”

Indeed, the Russell 2000 Index was created in 1984. Ibbotson’s small-cap returns go back to 1926, using the stocks in the bottom one-fifth of the New York Stock Exchange as measured by market capitalization. In 2001, Ibbotson switched to stocks tracked by Dimensional Fund Advisors and now uses the results of the DFA U.S. Micro Cap Portfolio to represent small-company stocks’ returns.


For perspective, advisors might think of small-cap funds as small, smaller and smallest. Morningstar puts the average market cap of its “small blend” (growth and value stocks) category at $2.7 billion. Many small-cap funds use the Russell 2000 as a benchmark. The iShares Russell 2000 ETF (IWM), with over $26 billion in assets, can be considered smaller, with an average market cap of $1.44 billion. In this sequence, microcap funds would be the smallest: for instance, the iShares Micro-Cap ETF (IWC), which tracks the Russell Microcap Index and has just under $1 billion in assets, consists of stocks with an average market cap of $409 million.

Such relatively tiny stocks can be volatile, of course. Ibbotson’s category of small-company stocks lost 36.7% in 2008. Yet the long-term returns have been strong. In the bull-bear-bull-bear-bull skirmishes from 1995 through 2013, those stocks had an annualized return of 12.5%, virtually identical to their 88-year performance.


Considering the risks and the historic performance, does it make sense to include microcaps in clients’ portfolios? “Yes,” Leonard says. “These stocks should be part of an overall diversified approach to asset classes, spread across the world. For our clients, we allocate about one-third of their equities toward true small-cap. That is both small-cap market and small-cap value in the U.S., in developed non-U.S., and in emerging markets.”

Does that mean that Leonard’s clients hold some broad small-cap funds and some other small-cap funds focusing on value stocks? “Exactly,” he says. “A broad small-cap fund weighs stocks purely by market cap, while a small-cap value fund starts with value and then weighs stocks by market cap. I have a value bias in addition to a small-cap bias.”

Some studies indicate that value stocks have topped growth stocks over the long term, so putting a few chips on microcap funds and small-cap value funds might tilt the odds in an investor’s favor.

Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

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